MB0050 –Research MethodologyQ1

a) Differentiate between nominal, ordinal, interval and ratio scales, with an example of each.

b) What are the purposes of measurement in social science research?Answer:a. There are four types of data that may be gathered in social research, each one adding

more to the next. Thus ordinal data is also nominal, and so on.NominalThe name 'Nominal' comes from the Latin nomen, meaning 'name' and nominal data are items which are differentiated by a simple naming system. The only thing a nominal scale does is to say that items being measured have something in common, although this may not be described. Nominal items may have numbers assigned to them. This may appear ordinal but is not -- these are used to simplify capture and referencing. Nominal items are usually categorical, in that they belong to a definable category, such as 'employees'.Example

The number pinned on a sports person.A set of countries.

OrdinalItems on an ordinal scale are set into some kind of order by their position on the scale. This may indicate such as temporal position, superiority, etc. The order of items is often defined by assigning numbers to them to show their relative position. Letters or other sequential symbols may also be used as appropriate. Ordinal items are usually categorical, in that they belong to a definable category, such as '1956 marathon runners'. You cannot do arithmetic with ordinal numbers -- they show sequence only.Example

The first, third and fifth person in a race.Pay bands in an organization, as denoted by A, B, C and D.

IntervalInterval data (also sometimes called integer) is measured along a scale in which each position is equidistant from one another. This allows for the distance between two pairs to be equivalent in some way. This is often used in psychological experiments that measure attributes along an arbitrary scale between two extremes. Interval data cannot be multiplied or divided.Example

My level of happiness, rated from 1 to 10.Temperature, in degrees Fahrenheit.

RatioIn a ratio scale, numbers can be compared as multiples of one another. Thus one person can be twice as tall as another person. Important also, the number zero has meaning.Thus the difference between a person of 35 and a person 38 is the same as the difference between people who are 12 and 15. A person can also have an age of zero.Ratio data can be multiplied and divided because not only is the difference between 1 and 2 the same as between 3 and 4, but also that 4 is twice as much as 2.Interval and ratio data measure quantities and hence are quantitative. Because they can be measured on a scale, they are also called scale data.

1

ExampleA person's weightThe number of pizzas I can eat before fainting

b. Purpose of measurement in social science.One of the primary purposes of classifying variables according to their level or scale of measurement is to facilitate the choice of a statistical test used to analyze the data. There are certain statistical analyses which are only meaningful for data which are measured at certain measurement scales. For example, it is generally inappropriate to compute the mean for Nominal variables. Suppose you had 20 subjects, 12 of which were male, and 8 of which were female. If you assigned males a value of '1' and females a value of '2', could you compute the mean sex of subjects in your sample? It is possible to compute a mean value, but how meaningful would that be? How would you interpret a mean sex of 1.4? When you are examining a Nominal variable such as sex, it is more appropriate to compute a statistic such as a percentage (60% of the sample was male).

When a research wishes to examine the relationship or association between two variables, there are also guidelines concerning which statistical tests are appropriate. For example, let's say a University administrator was interested in the relationship between student gender (a Nominal variable) and major field of study (another Nominal variable). In this case, the most appropriate measure of association between gender and major would be a Chi-Square test. Let's say our University administrator was interested in the relationship between undergraduate major and starting salary of students' first job after graduation. In this case, salary is not a Nominal variable; it is a ratio level variable. The appropriate test of association between undergraduate major and salary would be a one-way Analysis of Variance (ANOVA), to see if the mean starting salary is related to undergraduate major. Finally, suppose we were interested in the relationship between undergraduate grade point average and starting salary. In this case, both grade point average and starting salary are ratio level variables. Now, neither Chi-square nor ANOVA would be appropriate; instead, we would look at the relationship between these two variables using the Pearson correlation coefficient.

2

Q2

a) What are the sources from which one may be able to identify research problems?b) Why literature survey is important in research?

Answer:

a. Identifying research ProblemThis involves the identification of a general topic and formulating it into a specific research problem. It requires thorough understanding of the problem and rephrasing it in meaningful terms from an analytical point of view.Types of Research Projects

Those that relate to states of nature Those which relate to relationships between variables

In understanding the problem, it is helpful to discuss it with colleagues or experts in the field. It is also necessary to examine conceptual and empirical literature on the subject. After the literature review, the researcher is able to focus on the problem and phrase it in analytical or operational terms. The task of defining the research problem is of greatest importance in the entire research process. Being able to define the problem unambiguously helps the researcher in discriminating relevant data from irrelevant ones.Extensive literature reviewReview of literature is a systematic process that requires careful and perceptive reading and attention to detail. In the review of the literature, the researcher attempts to determine what others have learned about similar research problems. It is important in the following ways:

Specifically limiting and identifying the research problem and possible hypothesis or research questions i.e. sharpening the focus of the research.

Informing the researcher of what has already been done in the area. This helps to avoid exact duplication.

“If one had the literature and exercised enough patience and industry in reviewing available literature, it may well be that his problem has already been solved by someone somewhere some time ago and he will save himself the trouble.” Nwana (1982).

Providing insights into possible research designs and methods of conducting the research and interpreting the results.

Providing suggestions for possible modifications in the research to avoid unanticipated difficulties.

The library is the most likely physical location for the research literature. Within the library there is access to books, periodicals, technical reports and academic theses. Other sources are the Education Index and the Educational Resources information centre (ERIC). Computer-assisted searchers of literature have become very common today. They have the advantage of comprehensiveness and speed. They are also very cost-effective in terms of time and effort although access to some of the databases requires payment. Irrespective of the sources of the literature, ethics of research require that the source is acknowledged through a clear system of referencing.

b. Doing a literature survey before you begin your investigation enables you to take advantage of the unique human capacity to pass on detailed written information from one generation to another. Reading all the knowledge that's accumulated so far on the problem you want to study can be time-consuming and even tedious. But careful evaluation of that material helps make your investigation worthwhile by alerting you to knowledge already gained and problems already encountered in your areas of interest.

3

A literature survey amounts to reading available material on a given topic, analyzing and organizing findings, and producing a summary. There are many sources for literature reviews, including journals of general interest in each discipline, such as the American Political Science Review. There are also journals for specific topics such as the Leadership and Organization Development Journal. Governments publish great quantities of data on many topics. The United Nations and the United States Government Printing Office are two major sources. In addition, businesses and private organizations gather and publish information you might find useful. For certain problems you may want to search through popular or non-scholarly periodicals as well. While it's customary to include only data from sources that actually research the problem in a precise fashion, articles in more popular sources may provide interesting insight or orientations. Talking to knowledgeable people may also give you information that helps you formulate your problem.

Thoroughness is the key. Most libraries have staff trained in information retrieval who can help find sources and suggest strategies to review the literature. The Internet, of course, now allows easy access to limitless information on given topics. Thoroughness in your review means not only finding all current publications on a topic but locating earlier writing as well. There's no easy rule for how long ago literature was published on your topic. The time varies from problem to problem. A useful way to locate past as well as current writing is to begin with the most current sources likely to contain relevant material. Then, follow these authors' footnotes and bibliographies. At some point in this search you'll find the material is beginning to be only peripherally related to your current interest or that authors claim originality for their work.Of course, doing a good literature survey is easier when you know a great deal about the subject already. In such a case you'd probably be familiar with publications and even other people who do research in your area of interest. But for the novice, efficient use of library/Internet services and organizing how they check sources are especially important skills.Having located literature, keeping a checklist of useful information will help you read each source. You might ask yourself, particularly for research articles:

1. What was the exact problem studied?2. How were the topics of interest defined?3. What did the authors expect to find?4. How were things measured?5. What research did this author cite? Have you read it?6. Who were the subjects of study?7. What do the results show?8. Do the data presented agree with the written conclusions?9. What were the limitations of the study?

A thorough literature survey should demonstrate that you've carefully read and evaluated each article or book. Because research reports can be tedious and difficult to understand for new researchers, many tend to read others' conclusions or summaries and take the author's word that the data actually support the conclusions. Careful reading of both tables and text for awhile will convince you they don't always agree. Sometimes data are grossly misinterpreted in the text, but on other occasions authors are more subtle. Consider, for example, the following statements:

Fully 30 percent of the sample said they did not vote. Only 30 percent of the sample said they did not vote.

4

The percentage is the same, but the impression conveyed is decidedly different. Reading the actual data before accepting the author's conclusions will help prevent some of these errors of interpretation from creeping into your own research. It's important that after you finish your reading, you're able to write your literature survey in a way that's clear, organizing what you know about the content and methods used to study your problem. You may find it helpful to record information about each source on a separate card or piece of paper so that information can later be reshuffled, compared, and otherwise reorganized. Note in most journal articles that what probably began as a long literature survey is usually condensed on the first few pages of the research report, explaining previous research on the problem and how the current study will contribute. You, too, want to add to this growing body of knowledge we call social science by a creative summary of what's been accomplished by others as well as by your own research.

5

Q3a) What are the characteristics of a good research design? b) What are the components of a research design?

Answer:a)A research design is the arrangement of conditions for collection and analysis of data in a manner that aims to combine relevance to the research purpose with economy in procedure” Is the conceptual structure within which research is conducted; it constitutes the blueprint for the collection, measurement and analysis of data more explicitly:

1. It is a series of guide posts to keep one going in the right direction. 2. It reduces wastage of time and cost. 3. It encourages co-ordination and effective organization.4. It is a tentative plan which undergoes modifications, as circumstances demand, when

the study progresses, new aspects, new conditions and new relationships come to light and insight into the study deepens.

5. It has to be geared to the availability of data and the cooperation of the informants.6. It has also to be kept within the manageable limits

b. Components of Research Design It is important to be familiar with the important concepts relating to research design. They are:

1. Dependent and Independent variables: A magnitude that varies is known as a variable. The concept may assume different quantitative values, like height, weight, income, etc. Qualitative variables are not quantifiable in the strictest sense of objectivity. However, the qualitative phenomena may also be quantified in terms of the presence or absence of the attribute considered. Phenomena that assume different values quantitatively even in decimal points are known as „continuous variables‟. But, all variables need not be continuous. Values that can be expressed only in integer values are called „non-continuous variables‟. In statistical term, they are also known as „discrete variable‟. For example, age is a continuous variable; where as the number of children is a non-continuous variable. When changes in one variable depends upon the changes in one or more other variables, it is known as a dependent or endogenous variable, and the variables that cause the changes in the dependent variable are known as the independent or explanatory or exogenous variables. For example, if demand depends upon price, then demand is a dependent variable, while price is the independent variable.

2. Extraneous variable: The independent variables which are not directly related to the purpose of the study but affect the dependent variable are known as extraneous variables. For instance, assume that a researcher wants to test the hypothesis that there is relationship between children‟s school performance and their self-concepts, in which case the latter is an independent variable and the former, the dependent variable. In this context, intelligence may also influence the school performance. However, since it is not directly related to the purpose of the study undertaken by the researcher, it would be known as an extraneous variable. The influence caused by the extraneous variable on the dependent variable is technically called as an „experimental error‟. Therefore, a research study should always be framed in such a manner that the dependent variable completely influences the change in the independent variable and any other extraneous variable or variables.

3. Control: One of the most important features of a good research design is to minimize the effect of extraneous variable. Technically, the term control is used when a researcher designs the study in such a manner that it minimizes the effects of

6

extraneous independent variables. The term control is used in experimental research to reflect the restrain in experimental conditions.

4. Confounded relationship: The relationship between dependent and independent variables is said to be confounded by an extraneous variable, when the dependent variable is not free from its effects.

5. Research hypothesis: When a prediction or a hypothesized relationship is tested by adopting scientific methods, it is known as research hypothesis. The research hypothesis is a predictive statement which relates a dependent variable and an independent variable. Generally, a research hypothesis must consist of at least one dependent variable and one independent variable. Whereas, the relationships that are assumed but not be tested are predictive statements that are not to be objectively verified are not classified as research hypothesis.

6. Experimental and control groups: When a group is exposed to usual conditions in an experimental hypothesis-testing research, it is known as „control group‟. On the other hand, when the group is exposed to certain new or special condition, it is known as an „experimental group‟. In the afore-mentioned example, the Group A can be called a control group and the Group B an experimental one. If both the groups A and B are exposed to some special feature, then both the groups may be called as „experimental groups‟. A research design may include only the experimental group or the both experimental and control groups together.

7. Treatments: Treatments are referred to the different conditions to which the experimental and control groups are subject to. In the example considered, the two treatments are the parents with regular earnings and those with no regular earnings. Likewise, if a research study attempts to examine through an experiment regarding the comparative impacts of three different types of fertilizers on the yield of rice crop, then the three types of fertilizers would be treated as the three treatments.

8. Experiment: An experiment refers to the process of verifying the truth of a statistical hypothesis relating to a given research problem. For instance, experiment may be conducted to examine the yield of a certain new variety of rice crop developed. Further, Experiments may be categorized into two types namely, absolute experiment and comparative experiment. If a researcher wishes to determine the impact of a chemical fertilizer on the yield of a particular variety of rice crop, then it is known as absolute experiment. Meanwhile, if the researcher wishes to determine the impact of chemical fertilizer as compared to the impact of bio-fertilizer, then the experiment is known as a comparative experiment.

9. Experiment unit: Experimental units refer to the predetermined plots, characteristics or the blocks, to which the different treatments are applied. It is worth mentioning here that such experimental units must be selected with great caution.

10. Experimental and Non-Experimental Hypothesis Testing Research When the objective of a research is to test a research hypothesis, it is known as a hypothesis-testing research. Such research may be in the nature of experimental design or non-experimental design. A research in which the independent variable is manipulated is known as „experimental hypothesis-testing research‟, where as a research in which the independent variable is not manipulated is termed as „non-experimental hypothesis-testing research‟. E.g., assume that a researcher wants to examine whether family income influences the social attendance of a group of students, by calculating the coefficient of correlation between the two variables. Such an example is known as a non-experimental hypothesis-testing research, because the independent variable family income is not manipulated. Again assume that the researcher randomly selects 150 students from a group of students who pay their school fees regularly and them classifies them into tow sub-groups by randomly including 75 in Group A, whose parents have regular earning, and 75 in group B, whose parents do not have regular earning. And that at the end of the study, the researcher conducts a test on each group in order to examine the effects of regular

7

earnings of the parents on the school attendance of the student. Such a study is an example of experimental hypothesis-testing research, because in this particular study the independent variable regular earnings of the parents have been manipulated

8

Q4

a) Distinguish between Doubles sampling and multiphase sampling.b) What is replicated or interpenetrating sampling?

Answer:a. Double Sampling: Sample size calculations for a continuous outcome require specification of the anticipated variance; inaccurate specification can result in an underpowered or overpowered study. For this reason, adaptive methods whereby sample size is recalculated using the variance of a subsample have become increasingly popular. The first proposal of this type (Stein, 1945, Annals of Mathematical Statistics 16, 243-258) used all of the data to estimate the mean difference but only the first stage data to estimate the variance. Stein's procedure is not commonly used because many people perceive it as ignoring relevant data. This is especially problematic when the first stage sample size is small, as would be the case if the anticipated total sample size were small. A more naive approach uses in the denominator of the final test statistic the variance estimate based on all of the data. Applying the Helmert transformation, we show why this naive approach underestimates the true variance and how to construct an unbiased estimate that uses all of the data. We prove that the type I error rate of our procedure cannot exceed alpha.Double sampling refers to the subsection of the final sample form a pre-selected larger sample that provided information for improving the final selection. When the procedure is extended to more than two phases of selection, it is then, called multi-phase sampling. This is also known as sequential sampling, as sub-sampling is done from a main sample in phases. Double sampling or multiphase sampling is a compromise solution for a dilemma posed by undesirable extremes. “The statistics based on the sample of ‘n’ can be improved by using ancillary information from a wide base: but this is too costly to obtain from the entire population of N-elements. Instead, information is obtained from a larger preliminary sample n which includes the final sample n. extraneous Double sampling refers to the subsection of the final sample form a pre-selected larger sample that provided information for improving the final selection. When the procedure is extended to more than two phases of selection, it is then, called multi-phase sampling. This is also known as sequential sampling, as sub-sampling is done from a main sample in phases. Double sampling or multiphase sampling is a compromise solution for a dilemma posed by undesirable extremes. “The statistics based on the sample of ‘n’ can be improved by using ancillary information from a wide base: but this is too costly to obtain from the entire population of N elements. Instead, information is obtained from a larger preliminary sample n L which includes the final sample n.

Multistage sampling is a complex form of cluster sampling.

Advantages

cost and speed that the survey can be done in convenience of finding the survey sample normally more accurate than cluster sampling for the same size sample

Disadvantages

Is not as accurate as SRS if the sample is the same size More testing is difficult to do

Using all the sample elements in all the selected clusters may be prohibitively expensive or not necessary. Under these circumstances, multistage cluster sampling becomes useful.

9

Instead of using all the elements contained in the selected clusters, the researcher randomly selects elements from each cluster. Constructing the clusters is the first stage. Deciding what elements within the cluster to use is the second stage. The technique is used frequently when a complete list of all members of the population does not exist and is inappropriate.In some cases, several levels of cluster selection may be applied before the final sample elements are reached. For example, household surveys conducted by the Australian Bureau of Statistics begin by dividing metropolitan regions into 'collection districts', and selecting some of these collection districts (first stage). The selected collection districts are then divided into blocks, and blocks are chosen from within each selected collection district (second stage). Next, dwellings are listed within each selected block, and some of these dwellings are selected (third stage). This method means that it is not necessary to create a list of every dwelling in the region, only for selected blocks. In remote areas, an additional stage of clustering is used, in order to reduce travel requirements.Although cluster sampling and stratified sampling bear some superficial similarities, they are substantially different. In stratified sampling, a random sample is drawn from all the strata, where in cluster sampling only the selected clusters are studied, either in single stage or multi stage.

b. Replicated or Interpenetrating SamplingIt involves selection of a certain number of sub-samples rather than one full sample from a population. All the sub-samples should be drawn using the same sampling technique and each is a self-contained and adequate sample of the population. Replicated sampling can be used with any basic sampling technique: simple or stratified, single or multi-stage or single or multiphase sampling. It provides a simple means of calculating the sampling error. It is practical. The replicated samples can throw light on variable non-sampling errors. But disadvantage is that it limits the amount of stratification that can be employed.

10

Q5 a. How is secondary data useful to researcher? b. What are the criteria used for evaluation of secondary data?

Answer:a.Secondary Sources of Data These are sources containing data which have been collected and compiled for another purpose. The secondary sources consists of readily compendia and already compiled statistical statements and reports whose data may be used by researchers for their studies e.g., census reports , annual reports and financial statements of companies, Statistical statement, Reports of Government Departments, Annual reports of currency and finance published by the Reserve Bank of India, Statistical statements relating to Co-operatives and Regional Banks, published by the NABARD, Reports of the National sample survey Organization, Reports of trade associations, publications of international organizations such as UNO, IMF, World Bank, ILO, WHO, etc., Trade and Financial journals newspapers etc. Secondary sources consist of not only published records and reports, but also unpublished records. The latter category includes various records and registers maintained by the firms and organizations, e.g., accounting and financial records, personnel records, register of members, minutes of meetings, inventory records etc.

Features of Secondary Sources Though secondary sources are diverse and consist of all sorts of materials, they have certain common characteristics. First, they are readymade and readily available, and do not require the trouble of constructing tools and administering them. Second, they consist of data which a researcher has no original control over collection and classification. Both the form and the content of secondary sources are shaped by others. Clearly, this is a feature which can limit the research value of secondary sources.Finally, secondary sources are not limited in time and space. That is, the researcher using them need not have been present when and where they were gathered.

Use of Secondary Data The second data may be used in three ways by a researcher. First, some specific information from secondary sources may be used for reference purpose. For example, the general statistical information in the number of co-operative credit societies in the country, their coverage of villages, their capital structure, volume of business etc., may be taken from published reports and quoted as background information in a study on the evaluation of performance of cooperative credit societies in a selected district/state. Second, secondary data may be used as bench marks against which the findings of research may be tested, e.g., the findings of a local or regional survey may be compared with the national averages; the performance indicators of a particular bank may be tested against the corresponding indicators of the banking industry as a whole; and so on. Finally, secondary data may be used as the sole source of information for a research project. Such studies as securities Market Behaviour, Financial Analysis of companies, Trade in credit allocation in commercial banks, sociological studies on crimes, historical studies, and the like, depend primarily on secondary data. Year books, statistical reports of government departments, report of public organizations of Bureau of Public Enterprises, Censes Reports etc, serve as major data sources for such research studies.

11

Advantages of Secondary Data Secondary sources have some advantages:

1. Secondary data, if available can be secured quickly and cheaply. Once their source of documents and reports are located, collection of data is just matter of desk work. Even the tediousness of copying the data from the source can now be avoided, thanks to Xeroxing facilities.

2. Wider geographical area and longer reference period may be covered without much cost. Thus, the use of secondary data extends the researcher’s space and time reach.

3. The use of secondary data broadens the data base from which scientific generalizations can be made.

4. Environmental and cultural settings are required for the study. 5. The use of secondary data enables a researcher to verify the findings bases on

primary data. It readily meets the need for additional empirical support. The researcher need not wait the time when additional primary data can be collected.

b.Evaluation of Secondary Data :When a researcher wants to use secondary data for his research, he should evaluate them before deciding to use them. 1. Data Pertinence The first consideration in evaluation is to examine the pertinence of the available secondary data to the research problem under study. The following questions should be considered.

1. What are the definitions and classifications employed? 2. Are they consistent ? 3. What are the measurements of variables used? 4. What is the degree to which they conform to the requirements of our research? 5. What is the coverage of the secondary data in terms of topic and time?6. Does this coverage fit the needs of our research?

On the basis of above consideration, the pertinence of the secondary data to the research on hand should be determined, as a researcher who is imaginative and flexible may be able to redefine his research problem so as to make use of otherwise unusable available data.

2. Data Quality If the researcher is convinced about the available secondary data for his needs, the next step is to examine the quality of the data. The quality of data refers to their accuracy, reliability and completeness. The assurance and reliability of the available secondary data depends on the organization which collected them and the purpose for which they were collected. What is the authority and prestige of the organization? Is it well recognized? Is it noted for reliability? It is capable of collecting reliable data? Does it use trained and well qualified investigators? The answers to these questions determine the degree of confidence we can have in the data and their accuracy. It is important to go to the original source of the secondary data rather than to use an immediate source which has quoted from the original. Then only, the researcher can review the cautionary and other comments that were made in the original source.

3. Data Completeness The completeness refers to the actual coverage of the published data. This depends on the methodology and sampling design adopted by the original organization. Is the methodology sound? Is the sample size small or large? Is the sampling method appropriate? Answers to these questions may indicate the appropriateness and adequacy of the data for the problem under study. The question of possible bias should also be examined. Whether the purpose for which the original organization collected the data had a particular orientation? Has the study been made to promote the organization’s own interest? How the study was

12

conducted? These are important clues. The researcher must be on guard when the source does not report the methodology and sampling design. Then it is not possible to determine the adequacy of the secondary data for the researcher’s study.

13

Q6 What are the differences between observation and interviewing as methods of data collection? Give two specific examples of situations where either observation or interviewing would be more appropriate.Answer:

Observation vs interviewing as Methods of Data Collection

Collection of data is the most crucial part of any research project as the success or failure of the project is dependent upon the accuracy of the data. Use of wrong methods of data collection or any inaccuracy in collecting data can have significant impact on the results of a study and may lead to results that are not valid. There are many techniques of data collection along a continuum and observation and interviewing are two of the popular methods on this continuum that has quantitative methods at one end while qualitative methods at the other end. Though there are many similarities in these two methods and they serve the same basic purpose, there are differences that will be highlighted in this article.

ObservationObservation, as the name implies refers to situations where participants are observed from a safe distance and their activities are recorded minutely. It is a time consuming method of data collection as you may not get the desired conditions that are required for your research and you may have to wait till participants are in the situation you want them to be in. Classic examples of observation are wild life researchers who wait for the animals of birds to be in a natural habitat and behave in situations that they want to focus upon. As a method of data collection, observation has limitations but produces accurate results as participants are unaware of being closely inspected and behave naturally. Interviewing Interviewing is another great technique of data collection and it involves asking questions to get direct answers. These interviews could be either one to one, in the form of questionnaires, or the more recent form of asking opinions through internet. However, there are limitations of interviewing as participants may not come up with true or honest answers depending upon privacy level of the questions. Though they try to be honest, there is an element of lie in answers that can distort results of the project.Though both observation and interviewing are great techniques of data collection, they have their own strengths and weaknesses. It is important to keep in mind which one of the two will produce desired results before finalizing.

Observation vs Interviewing • Data collection is an integral part of any research and various techniques are employed for this purpose.• Observation requires precise analysis by the researcher and often produces most accurate results although it is very time consuming• Interviewing is easier but suffers from the fact that participants may not come up with honest replies. Interview format: Interviews take many different forms. It is a good idea to ask the organization in advance what format the interview will take.

14

Competency/criteria based interviews:

These are structured to reflect the competencies or qualities that an employer is seeking for a particular job, which will usually have been detailed in the job specification or advert. The interviewer is looking for evidence of your skills and may ask such things as: Give an example of a time you worked as part of a team to achieve a common goal.Technical interviews: If you have applied for a job or course that requires technical knowledge, it is likely that you will be asked technical questions or has a separate technical interview. Questions may focus on your final year project or on real or hypothetical technical problems. You should be prepared to prove yourself, but also to admit to what you do not know and stress that you are keen to learn. Do not worry if you do not know the exact answer - interviewers are interested in your thought process and logic. The Screening Interview: Companies use screening tools to ensure that candidates meet minimum qualification requirements. Computer programs are among the tools used to weed out unqualified candidates. (This is why you need a digital resume that is screening-friendly. See our resume centre for help.) Sometimes human professionals are the gatekeepers. Screening interviewers often have honed skills to determine whether there is anything that might disqualify you for the position. Remember they do not need to know whether you are the best fit for the position, only whether you are not a match. For this reason, screeners tend to dig for dirt. Screeners will hone in on gaps in your employment history or pieces of information that look inconsistent. They also will want to know from the outset whether you will be too expensive for the company. The Informational Interview: On the opposite end of the stress spectrum from screening interviews is the informational interview. A meeting that you initiate, the informational interview is underutilized by job-seekers who might otherwise consider themselves savvy to the merits of networking. Jobseekers ostensibly secure informational meetings in order to seek the advice of someone in their current or desired field as well as to gain further references to people who can lend insight. Employers that like to stay apprised of available talent even when they do not have current job openings, are often open to informational interviews, especially if they like to share their knowledge, feel flattered by your interest, or esteem the mutual friend that connected you to them. During an informational interview, the jobseeker and employer exchange information and get to know one another better without reference to specific job opening.

15

MB0051 – Legal Aspects of Business

Q.1 Distinguish between fraud and misrepresentation. Answer:

Meaning of fraud:Fraud means and includes any of the following acts committed by a party to a contractwith an intent to deceive the other party thereto or to induce him to enter into a contract: (i) the suggestion as a fact of that which is not true by one who does not believe it to be true; (ii) active concealment of a fact by one having knowledge or belief of the fact; (iii)promise made without any intention of performing it; (iv) any other act fitted to deceive;(v) any such act or omission as the law specifically declares to be fraudulent.

Meaning of misrepresentation:Misrepresentation is also known as simple misrepresentation whereas fraud is known as fraudulent misrepresentation. Like fraud, misrepresentation is an incorrect or falsestatement but the falsity or inaccuracy is not due to any desire to deceive or defraud theother party. Such a statement is made innocently. The party making it believes it to betrue. In this way, fraud is different from misrepresentation.

Difference between fraud and misinterpretation:- In misrepresentation the person making the false statement believes it to be true.

In fraud the false statement is person who knows that it is false or he does not care to know whether it is true or false.

There is no intention to deceive the other party when there is misrepresentation of fact. The very purpose of the fraud is to deceive the other party to the contract.

Misrepresentation renders the contract voidable at the option of the party whoseconsent was obtained by misrepresentation. In the case of fraud the contract isvoidable It also gives rise to an independent action in tort for damages.

Misrepresentation is not an offence under Indian penal code and hence not punishable. Fraud, In certain cases is a punishable offence under Indian penal code.

Generally, silence is not fraud except where there is a duty to speak or the relations between parties is fiduciary. Under no circumstances can silence be considered as misrepresentation.

The party complaining of misrepresentation can’t avoid the contract if he had themeans to discover the truth with ordinary deligance. But in the case of fraud, Theparty making a false statement cannot say that the other party had the means todiscover the truth with ordinary deligance.

16

Q.2 What are the remedies for breach of contract.Answer:

Remedies for Breach of ContractWhen someone breaches a contract, the other party is no longer obligated to keep its end of the bargain. From there, that party may proceed in several ways: (i) the other party may urge the breaching party to reconsider the breach; (ii) if it is a contract with a merchant, the other party may get help from consumers’ associations; (iii) the other party may bring the breaching party to an agency for alternative dispute resolution; (iv) the other party may sue for damages; or (v) the other party may sue for other remedies.

Rescission of the contract: When a breach of contract is committed by one party, the other party may treat the contract as rescinded. In such a case the aggrieved party is freed from all his obligations under the contract.

Damages: Another relief or remedy available to the promisee in the event of a breach of promise by the promisor is to claim damages or loss arising to him there from. Damages under Sec.75 are awarded according to certain rules as laid down in Secs.73-74. Sec.73 contains three important rules: (i) Compensation as general damages will be awarded only for those losses that directly and naturally result from the breach of the contract. (ii) Compensation for losses indirectly caused by breach may be paid as special damages if the party in breach had knowledge that such losses would also follow from such act of breach. (iii) The aggrieved party is required to take reasonable steps to keep his losses to the minimum.

The most common remedy for breach of contracts: The usual remedy for breach of contracts is suit for damages. The main kinds of damages awarded in a contract suit are ordinary damages. This is the amount of money it would take to put the aggrieved party in as good a position as if there had not been a breach of contract. The idea is to compensate the aggrieved party for the loss he has suffered as a result of the breach of the contract.

In addition to the rights of a seller against goods provided in Secs.47 to 54, the seller has the following remedies against the buyer personally. (i) suit for price (Sec.55); (ii) damages for non-acceptance of goods (Sec.56); (iii) suit for interest (Sec.56).

Suit for price (Sec.55): Where under a contract of sale the property in the goods has passed to the buyer and the buyer wrongfully neglects or refuses to pay the price, the seller can sue the buyer for the price of the goods. Where the property in goods has not passed to the buyer, as a rule, the seller cannot file a suit for the price; his only remedy is to claim damages.

Suit for damages for non-acceptance (Sec.56): Where the buyer wrongfully neglects or refuses to accept and pay for the goods, the seller may sue him for damages for non-acceptance. Where the property in the goods has not passed to the buyer and the price was not payable without passing of property, the seller can only sue for damages and not for the price. The amount of damages is to be determined in accordance with the provisions laid down in Sec.73 of the Indian Contract Act, 1872. Thus, where there is an available market for the goods prima facie, the difference between the market price and the contract price can be recovered.

17

Suit for interest (Sec.61): When under a contract of sale, the seller tenders the goods to the buyer and the buyer wrongfully refuses or neglects to accept and pay the price, the seller has a further right to claim interest on the amount of the price. In the absence of a contract to the contrary, the court may award interest at such rate as it thinks fit on the amount of the price. The interest may be calculated from the date of the tender of the goods or from the date on which the price was payable. It is obvious that the unpaid seller can claim interest only when he can recover the price, i.e., if the seller’s remedy is to claim damages only, then he cannot claim interest.

Buyer’s remedies against seller: The buyer has the following rights against the seller for breach of contract: (i) damages for non-delivery (Sec.57); (ii) right of recovery of the price; (iii) specific performance (Sec.58); (iv) suit for breach of condition; (v) suit for breach of warranty (Sec.59); (vi) anticipatory breach (Sec.60); (vii) recovery of interest (Sec.61).)

18

Q.3 Distinguish between indemnity and guarantee.Answer:

Distinction between a contract of guarantee and a contract of indemnity. L.C. Mather in his book “Securities Acceptable to the Lending Banker” has very briefly, but excellently, brought out the distinction between indemnity and guarantee by the following illustration. A contract in which A says to B, ‘If you lend £20 to C, I will see that your money comes back’ is an indemnity. On the other hand undertaking in these words, “If you lend £20 to C and he does not pay you, I will is a guarantee. Thus, in a contract of indemnity, there are only two parties, indemnifier and indemnified. In case of a guarantee, on the other hand, there are three parties, the ‘principal debtor’, the ‘creditor’ and the ‘surety’. Other points of difference are:

1. The liability of a promissory is primary and independent in a contract of indemnity. In a contract of guarantee, the liability of the surety is secondary, the primary liability being that of the principal debtor.

2. In the case of guarantee, there is an existing debt or obligation, the performance of which is guaranteed by the surety. In case of indemnity the possibility of any loss happening is a contingency against which the indemnifier undertakes to indemnify.

3. In a contract of guarantee, after discharging the debt, the surety is entitled to proceed against the principal debtor in his own name while in case of indemnity, the indemnifier cannot proceed against third parties in his own name, unless there is an assignment in his favour.

19

Q.4 What is the distinction between cheque and bill of exchange.Answer:

Bill of exchange:A ‘bill of exchange’ is defined by Sec.5 as ‘an instrument in writing, containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to or to the order of, a certain person, or to the bearer of the instrument’.

Cheques: A cheque is the usual method of withdrawing money from a current account with a banker. Savings bank accounts are also permitted to be operated by cheques provided certain minimum balance is maintained. A cheque, in essence, is an order by the customer of the bank directing his banker to pay on demand, the specified amount, to or to the order of the person named therein or to the bearer. Sec.6 defines a cheque. TheAmendment Act 2002 has substituted new section for Sec.6. It provides that a ‘cheque’ is a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand and it includes the electronic image of a truncated cheque and a cheque in the electronic from.

Check Bill of Exchange

It is drawn on a banker It may be drawn on any party or individual.

It has three parties - the drawer, the drawee, and payee.

There are three parties - the drawer, the drawee, and the payee.

It is seldom drawn in sets Foreign bills are drawn in sets

It does not require acceptance by the drawee.

It must be accepted by the drawee before he can be made liable to pay the bill.

Days of grace are not allowed to a banker

Three days of grace are always allowed to the drawee.

No stamp duty is payable on checks Stamp duty has to be paid on bill of exchange.

It is usually drawn on the printed It may be drawn in any paper and need not necessarily be printed

20

Q.5. Distinguish between companies limited by shares and companies limited by guarantee.Answer:

The Companies Act, 1956 defines the word “company as a company formed and registered under the Act or an existing company formed and registered under any of the previous company laws (Sec.3)”. This definition does not bring out the meaning and nature of the company into a clear perspective. Also Sec.12 permits the formation of different types of companies. These may be:

1. Companies limited by shares 2. Companies limited by guarantee and 3. Unlimited companies.

The vast majority of companies in India are with limited liability by shares. Distinction between Cheque and bill of exchange

Companies limited by shares Companies limited by guarantee

A company limited by guarantee is normally incorporated for nonprofit making functions. The company has no share capital. A company limited by guarantee has members rather than shareholders. The members of the company guarantee/undertake to contribute a predetermined sum to the liabilities of the company which becomes due in the event of the company being wound up. The Memorandum normally includes a non-profit distribution clause and these companies are usually formed by clubs, professional, trade or research associations.

Limited by shares is defined by: a company that has shareholders, and that the financial obligation of the shareholders to creditors of the company is restricted to the capital invested in the first place (i.e. the specified value of the shares and any premium paid off in exchange for the issue of the shares by the company). Shareholder's individual’s assets are there by secured in the case of the company's insolvency, but revenues invested in the company will be unrecoverable. Limited companies could be either private or public. A private Ltd. (limited company disclosure) involves are less demanding, but for this reason its shares might NOT be provided to the general public (and consequently can't be listed on a national stock market exchange). This is the well-known distinctive characteristic between a private limited company and a public limited company. The absolute majority of trading corporations are private companies limited by shares

.Companies limited by shares are more popular

Companies limited by guarantee are less popular than companies limited by shares.

Companies limited by shares are profit making companies.

Companies limited by guarantee are non-profit making. In case of companies limited by shares, there are shareholders.

21

Companies limited by guarantee have members, and not share holders

Companies limited by shares can engage in legal trades and have general clauses. There is no share capital in case of companies limited by guarantee and it also has self-imposed restrictions

22

Q6. What are the various categories of Cybercrimes?Answer:

Introduction: Crime and criminality have been associated with man since his fall. Crime remains elusive and ever strives to hide itself in the face of development. Different nations have adopted different strategies to contend with crime depending on their nature and extent. One thing is certain, it is that a nation with high incidence of crime cannot grow or develop. That is so because crime is the direct opposite of development. It leaves a negative social and economic consequence. Cybercrime: Cybercrime is defined as crimes committed on the internet using the computer as either a tool or a targeted victim. It is very difficult to classify crimes in general into distinct groups as many crimes evolve on a daily basis. Even in the real world, crimes like rape, murder or theft need not necessarily be separate. However, all cyber crimes involve both the computer and the person behind it as victims; it just depends on which of the two is the main target. Hence, the computer will be looked at as either a target or tool for simplicity’s sake. For example, hacking involves attacking the computer’s information and other resources. It is important to take note that overlapping occurs in many cases and it is impossible to have a perfect classification system. Computer as a tool: When the individual is the main target of Cybercrime, the computer can be considered as the tool rather than the target. These crimes generally involve less technical expertise as the damage done manifests itself in the real world. Human weaknesses are generally exploited. The damage dealt is largely psych logical and intangible, making legal action against the variants more difficult. These are the crimes which have existed for centuries int he offline. Scams, theft, and the likes have existed even before the development in high-tech equipment. The same criminal has simply been given a tool which increases his potential pool of victims and makes him all the harder to trace and apprehend.

Computer as a target: These crimes are committed by a selected group of criminals. Unlike crimes using he computer as a tool, these crimes requires the technical knowledge of the perpetrators. These crimes are relatively new, having been inexistence for only as long as computers have - which explains how unprepared society and the world in general is towards combating these crimes. There are numerous crimes of this nature committed daily on the internet. But it is worth knowing that Africans and indeed Nigerians are yet to develop their technical knowledge to accommodate and perpetrate this kind of crime. The internet in India is growing rapidly. It has given rise to new opportunities in every field we can think of – be it entertainment, business, sports or education. There are two sides to a coin. Internet also has its own disadvantages. One of the major disadvantages is Cybercrime – illegal activity committed on the internet. The internet, along with its advantages, has also exposed us to security risks that come with connecting to a large network. Computers today are being misused for illegal activities like e-mail espionage, credit car fraud, spams, and software piracy and so on, which invade our privacy and offend our senses. Criminal activities in the cyberspace are on the rise. Here we publish an article by Nandini Ram prasad in series for the benefit of our netizens.

23

Cybercrimes can be basically divided into 3 major categories: 1) Cybercrimes against persons2) Cybercrimes against property. 3) Cybercrimes against government. Cybercrimes committed against persons include various crimes like transmission of child-pornography, harassment of any one with the use of a computer such as e-mail. The trafficking, distribution, posting, and dissemination of obscene material including pornography and indecent exposure, constitutes one of the most important Cybercrimes known today. The potential harm of such a crime to humanity can hardly be amplified. This is one Cybercrime which threatens to undermine the growth of the younger generation as also leave irreparable scars and injury on the younger generation, if not controlled. In the United States alone, the virus made its way through 1.2 million computers in one-fifth of the country's largest businesses. David Smith pleaded guilty on Dec. 9, 1999 to state and federal charges associated with his creation of the Melissa virus. There are numerous examples of such computer viruses few of them being "Melissa" and "love bug". A Mumbai-based upstart engineering company lost a say and much money in the business when the rival company, an industry major, stole the technical database from their computers with the help of a corporate cyber spy. Unauthorized access: Using one's own programming abilities as also various programs with malicious intent to gain unauthorized access to a computer or network are very serious crimes. Similarly, the creation and dissemination of harmful computer programs which do irreparable damage to computer systems is another kind of Cybercrime. Software piracy is also another distinct kind of Cybercrime which is perpetuated by many people online who distribute illegal and unauthorized pirated copies of software. Professionals who involve in these cybercrimes are called crackers and it is found that many of such professionals are still in their teens. A report written near the start of the Information Age warned that America's computers were at risk from crackers. It said that computers that "control (our) power delivery, communications, aviation and financial services (and) store vital information, from medical re-cords to business plans, to criminal records", were vulnerable from many sources, including deliberate attacks

24

MF0010– Security Analysis and Portfolio Management

Q1 Frame the investment process for a person of your age group. Answer:It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps:

1. Setting Investment Policy This initial step determines the investor’s objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash. The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk.

2. Time Horizon The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughter’s college education would be less likely to take a large risk because he has a shorter time horizon.

3. Risk Tolerance Risk tolerance is an investor’s ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a

25

1. Set investment policy

4. Evaluate the performance of portfolio

2. Perform Security Analysis

3. Construct a portfolio

5. Revise the portfolio

high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. The conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush." While setting the investment policy, the investor also selects the portfolio management style (active vs. passive management).

Active Management is the process of managing investment portfolios by attempting to time the market and/or select „undervalued‟ stocks to buy and „overvalued‟ stocks to sell, based upon research, investigation and analysis.

Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as possible, by holding all or a representative sample of the securities in the index or asset class. This portfolio management style does not use market timing or stock selection strategies.

2. Performing Security Analysis This step is the security selection decision: Within each asset type, identified in the asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units). Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuer's income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the „basics‟ of the business. Technical analysis is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform. 3. Portfolio Construction This step identifies those specific assets in which to invest, as well as determining the proportion of the investors wealth to put into each one. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio in such a way that the investor‟s risk is minimized.

The following table summarizes how the portfolio is constructed for an active and a passive investor. Asset Allocation

Security Selection

Active investor Market timing Stock picking Passive investor Maintain pre-

determined selections

Try to track a well-known market index like Nifty, Sensex

4. Portfolio Revision This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one. 5. Portfolio performance evaluation

26

This step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred).

Q2 From the website of BSE India, explain how the BSE Sensex is calculated. Answer:An index is a statistical indicator providing a representation of the value of the securities which constitute it. Indexes often serve as barometers for a given market or industry and benchmarks against which financial or economic performance is measured. A stock index reflects the price movement of shares while a bond index captures the manner in which bond prices go up and down. For more than hundred years, people have tracked the market’s daily ups and downs using various indices of overall market performance. There are currently thousands of indices calculated by various information providers. Internationally, the best known indices are provided by Dow Jones & Co, S & P, Morgan Stanley Capital Markets (MSCI), Lehman Brothers (bond indices). Dow Jones alone currently publishes more than 3,000 indices. Some of the well-known indices are Dow Jones Industrial Average (DJIA), Standard & Poor‟s 500 Index (S&P 500), Nasdaq Composite, Nasdaq 100, Financial Times-Stock Exchange 100 (FTSE 100), Nikkei 225 Stock Average, Hang Seng Index, Deutscher Aktienindex (DAX). In India the best known indices are Sensex and Nifty. Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of 30 stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. Sensex till August 31, 2003 was constructed on the basis of full market capitalization. A need was felt to switch over to free float wherein non-promoter and non-strategic shareholdings are eliminated and only those outstanding shares that are available for trading are included. Sensex since 31st September, 2003, is being constructed on free float market capitalization.

Free Float Market CapitalizationCurrently all equity indices in India, except the BSE-TECk Index and BANKEX, are calculated using the 'full-market capitalization' methodology. Under the 'full-market capitalization' methodology, the total market capitalization of a company, irrespective of who is holding the shares, is taken into consideration for computation of an index. However, if instead of taking the total market capitalization, only the Free-float market capitalization of a company is considered for index calculation, it is called the Free-float methodology. Free-float market capitalization is defined as that proportion of total shares issued by the company, which are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares, which will not come to the market for trading in the normal course. Thus, the market capitalization of each company in a Free-float index is reduced to the extent of its Free-float available in the market. A Free-float based index is regarded as a better benchmark in comparison to a full market capitalization weighted index. It not only reflects the market trends in a more rational manner, but also aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis-à-vis an investable index. This enables an apple-to-apple comparison thereby facilitating better evaluation of performance of active managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. Advantages of Free float Market Capitalization: A Free-float Index reflects the market movements better. It aids passive investment because a Free-float index is easily replicable It improves index flexibility and the resultant market coverage and sector coverage

27

It avoids the undue influence of any closely-held large-capitalization stock on the index movement

It is considered as a global best practice in index construction.

How does BSE determine the Free-float factor for each Index Company?

BSE has designed a detailed Free-float format to be filled and submitted by all index companies on a quarterly basis with the Exchange. (Format available on www.bseindia.com) The Exchange determines the Free-float factor for each company based on the detailed information submitted by the companies. Free-float factor is the multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. Once the Free-float factor of a company is determined, it is rounded-off to the higher multiple of 10 and each company is categorized into one of the bands given below. The banding structure reduces the potential of frequent changes in Free-float factors of index companies. A Free-float factor of say 0.6 means that only 60% of the market capitalization of the company will be considered for index calculation.

Free-float Market Capitalization

Free-float Adjustment factor

10-20% 0.220-30% 0.330-40% 0.440-50% 0.550-60% 0.660-70% 0.770-80% 0.880-90% 0.990-100% 1.0

28

29

30

Q4 Perform an economy analysis on Indian economy in the current situation.Answer:Economy analysis investors determine whether the economic climate offers a positive and encouraging investing environment. Economic analysis is done for two reasons: first, a company‟s growth prospects are, ultimately, dependent on the economy in which it operates; second, share price performance is generally tied to economic fundamentals, as most companies generally perform well when the economy is doing the same. Factors to be considered in economy analysis The economic variables that are considered in economic analysis are:

1. gross domestic product (GDP) growth rate, 2. exchange rates, 3. the balance of payments (BOP), 4. the current account deficit, 5. government policy (fiscal and monetary policy), 6. domestic legislation (laws and regulations), 7. unemployment (the percent of the population that wants to work and is currently not

working), 8. public attitude (consumer confidence) 9. inflation (a general increase in the price of goods and services), interest rates, 10. productivity (output per worker), 11. Capacity utilization (output by the firm) etc.

GDP is the total income earned by a country. GDP growth rate shows how fast the economy is growing. Investors know that strong economic growth is good for companies and recessions or full-blown depressions cause share prices to decline, all other things being equal. Inflation is important for investors, as excessive inflation undermines consumer spending power (prices increase) and so can cause economic stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages consumers to postpone spending (as they wait for cheaper prices). The exchange rate affects the broad economy and companies in a number of ways. First, changes in the exchange rate affect the exports and imports. If exchange rate strengthens, exports are hit; if the exchange rate weakens, imports are affected. The BOP affects the exchange rate through supply and demand for the foreign currency. BOP reflects a country’s international monetary transactions for a specific time period. It consists of the current account and the capital account. The current account is an account of the trade in goods and services. The capital account is an account of the cross-border transactions in financial assets. A current account deficit occurs when a country imports more goods and services than it exports. A capital account deficit occurs when the investments made in the country by foreigners is less than the investment in foreign countries made by local players. The currency of a country appreciates when there is more foreign currency coming into the country than leaving it. Therefore, a surplus in the current or capital account causes the currency to strengthen; a deficit causes the currency to weaken. The levels of interest rates (the cost of borrowing money) in the economy and the money supply (amount of money circulating in the economy) also have a bearing on the performance of businesses. All other things being equal, an increase in money supply causes the interest rates to fall; a decrease causes the interest rates to rise. If interest rates are low, the cost of borrowing by businesses is not expensive, and companies can easily borrow to expand and develop their activities.

31

On the other hand, when the cost of borrowing becomes too high (when the interest rates go up), borrowing may become too costly and plans for expansion are postponed. Interest rates also have a significant effect on the share markets. In very broad terms, share prices improve when interest rates fall and decline when interest rates increase. There are two reasons for that: the “intrinsic value” estimate will increase as interest rates (and the linked discount rate) fall and underlying company profitability will improve, if interest payments reduce.

Series Name2001

2002

2003

2004

2005

2006

2007

2008 2009 2010

GDP growth (annual %) 5 4 8 8 9 9 10 5 9 10

Series Name2001

2002

2003

2004

2005

2006

2007

2008 2009 2010

Inflation, consumer prices (annual %) 4 4 4 4 4 6 6 8 11 12

32

33

Series Name2001

2002

2003

2004

2005

2006

2007

2008 2009 2010

Inflation, GDP deflator (annual %) 3 4 4 9 4 6 6 7 8 10

34

Q4 Identify some technical indicators and explain how they can be used to decide purchase of a company’s stock. Answer:

Technical Indicators: The technical approach to investment is essentially a reflection of the idea that prices move in trends that are determined by the changing attitudes of investors toward a variety of economic, monetary, political and psychological forces. The art of technical analysis, for it is an art, is to identify a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed. The evidence in this case is represented by the numerous scientifically derived indicators described in this book.

Human nature remains more or less constant and tends to react to similar situations in consistent ways. By studying the nature of previous market turning points, it is possible to develop some characteristics that can help to identify market tops and bottoms. Therefore, technical analysis is based on the assumption that people will continue to make the same mistakes they have made in the past. Sentiment indicators are intended to measure the expectations of various groups of investors, for example, mutual fund investors, and corporate insiders. Sentiment or expectational indicators monitor the actions of different market participants, such as insiders, mutual funds managers and investors, and floor specialists. Just as the pendulum of a clock continually moves from one extreme to another, so the sentiment indexes (which monitor the emotions of investors) move from one extreme at a bear market bottom to another a at bull market top. The assumption on which these indicators are based is that different groups of investors are consistent in their actions at major market turning points. For example, insiders (that is, key employees or major stockholders of a company) and New York Stock Exchange (NYSE) members as a group have a tendency to be correct at market turning points; in aggregate, their transactions are on the buy side toward market bottoms and the sell side toward tops.

Conversely, advisory services as a group are often wrong at market turning points, since they consistently become bullish at market tops and bearish at market troughs. Indexes derived from such data show that certain readings have historically corresponded to market tops, while others have been associated with market bottoms. Since the consensus or majority opinion is normally wrong at market turning points, these indicators of market psychology are a useful basis from which to form a contrary opinion.

Flow of funds indicators are intended to measure the potential for various investor groups to buy or sell stocks, in order to predict the price pressure from those actions. The area of technical analysis that involves what are loosely termed flow-of-funds indicators analyzes the financial position of various investor groups in an attempt to measure their potential capacity for buying or selling stocks. Since there has to be a purchase for each sales, the ex post, or actual dollar balance between supply and demand for stock, must always be equal. The price at which a stock transaction takes place has to be the same for the buyer and the seller, so naturally the amount of money flowing out of the marketing must equal that put in. The flow-of-funds approach is therefore concerned with the before-the-fact balance between supply and demand, known as the ex ante relationship. If at a given price there is a preponderance of buyers over sellers on an ex ante basis, it follows that the actual (ex post) price will have to rise to bring buyers and sellers into balance.

35

Flow-of-funds analysis is concerned, for example, with trends in mutual fund cash positions and those of other major institutions, such as pension funds, insurance companies, foreign investors, bank trust accounts, and customers' free balances, which are normally a source of cash on the buy side. On the supply side, flow-of-funds analysis is concerned with new equity offerings, secondary offerings, and margin debt.

This money flow analysis also suffers from disadvantages. Although the data measure the availability of money for the stock market (for example, mutual fund cash position or pension fund cash flow), they give no indication of the inclination of market participants to use this money for the purchase of stock, or of their elasticity or willingness to sell at a given price on the sell side. The data for the major institutions and foreign investors are not sufficiently detailed to be of much use, and in addition they are reported well after the face. In spite of these drawbacks, flow-of-funds statistics may be used as background material.

Market structure indicators monitor price trends and cycles. This area of technical analysis is the main concern of this book, embracing market structure or the character of the market indicators. These indicators monitor the trend of various price indexes, market breadth, cycles, volume, and so on in order to evaluate the health of the prevailing trend.

Indicators that monitor the trend of a price include moving averages, peak-and-trough analysis, price patterns, and trendlines. Such techniques can also be applied to the sentiment and flow-of-funds indicators discussed previously. This is because these indicators also move in trends. When the trend of psychology, as reflected in these series, reverses, prices are also likely to change direction.

Most of the time, price and internal measures, such as market breadth, momentum, and volume, rise and fall together, but toward the end of market movements, the paths of many of these indicators diverge from the price. Such divergences offer signs of technical deterioration during advances, and technical strength following declines. Through judicious observation of these signs of latent strength and weakness, technically oriented investors are alerted to the possibility of a reversal in the trend of the market itself.

Since the technical approach is based on the theory that the price is a reflection of mass psychology, or the crowd in action, it attempts to forecast future price movements on the assumption that crowd psychology moves between panic, fear, and pessimism on one hand and confidence, excessive optimism, and greed on the other. As discussed here, the art of technical analysis is concerned with identifying these changes at an early phase, since these swings in emotion take time to accomplish. Studying these market trends enables technically oriented investors and traders to buy or sell with a degree of confidence in the principle that once a trend is set in motion, it will perpetuate itself.

36

Q5 Compare Arbitrage pricing theory with the Capital asset pricing model.Answer:

Arbitrage Pricing Theory (APT), has been developed by Stephen Ross. It can calculate expected return without taking recourse to the market portfolio. It is a multi-factor model for determining the required rate of return which means that it takes into account a number of economy wide factors that can affect the security prices. APT calculates relations among expected returns that will rule out arbitrage by investors. The APT requires three assumptions:

1. Returns can be described by a factor model. 2. There are no arbitrage opportunities. 3. There are large numbers of securities that permit the formation of portfolios that

diversify the firm-specific risk of individual stocks.

APT starts with the assumption that security returns are related to an unknown number of unknown factors. These factors can be GDP (Gross domestic product), a market interest rate, the rate of inflation or any other random variable that impacts security prices. For simplicity, let us assume that there is only one factor (such as the GDP growth rate) that impacts the security price

The Capital Asset Pricing Model (CAPM) is a model to explain why capital assets are priced the way they are. William Sharpe, Treynor and Lintner contributed to the development of this model. An important consequence of the modern portfolio theory as introduced by Markowitz was that the only meaningful aspect of total risk to consider for any individual asset is its contribution to the total risk of a portfolio. CAPM extended Harry Markowitz‟s portfolio theory to introduce the notions of systematic and unsystematic (or unique) risk. With the introduction of risk-free lending and borrowing, the efficient frontier of Markowitz was expanded and it was shown that only one risky portfolio (the tangency portfolio) mattered in evaluating the portfolio risk contribution characteristics of any asset. CAPM demonstrated that the tangency portfolio was nothing but the Market Portfolio consisting of all risky assets in proportion to their market capitalization. Since the Market Portfolio includes all the risky assets in the world in their relative proportions, it is a fully diversified portfolio. The inherent risk of each asset that can be eliminated by belonging to the portfolio has already been eliminated. Only the market risk (also called Systematic Risk) remains. In other words, the benefit of risk reduction defined by modern portfolio theory has reached its ultimate limit. The CAPM is a model for risky asset pricing (i.e., defining an appropriate risk-adjusted required return for any risky asset. Using a statistical technique called linear regression, the total risk of each risky asset is separated into two components – the variability in its returns (i.e., risk) that is related with the variability of returns in the Market Portfolio (its contribution to systematic risk) and the variability in its returns that is unrelated with the variability of returns in the Market Portfolio (called unsystematic risk). The systematic risk of a risky asset matters; it exists in the Market Portfolio and cannot be eliminated by further diversification (all the assets are already there in the Market Portfolio). And since investors will want to hold the Market Portfolio, this is the risk that must be and is rewarded. The unsystematic risk for any risky asset cannot be eliminated by holding the Market Portfolio (which includes the risky asset in question). Thus the major conclusion of CAPM is that expected return on an asset is related to its systematic and not to its total risk or standard deviation. Its systematic risk is given by its beta coefficient (β). An asset‟s beta is a measure of its co-movement with the market index.Arbitrage Pricing Theory vs. the Capital Asset Pricing Model

37

The Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model are the two most influential theories on stock and asset pricing today. The APT model is different from the CAPM in that it is far less restrictive in its assumptions. APT allows the individual investor to develop their model that explains the expected return for a particular asset. Intuitively, the APT makes a lot of sense because it removes the CAPM restrictions and basically states that the expected return on an asset is a function of many factors and the sensitivity of the stock to these factors. As these factors move, so does the expected return on the stock - and therefore its value to the investor. However, the potentially large number of factors means that more factor sensitivities have to be calculated. There is also no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM. In the CAPM theory, the expected return on a stock can be described by the movement of that stock relative to the rest of the stock market. The CAPM theory is really just a simplified version of the APT, where the only factor considered is the risk of a particular stock relative to the rest of the stock market - as described by the stock's beta. From a practical standpoint, CAPM remains the dominant pricing model used today. When compared to the Arbitrage Pricing Theory, the Capital Asset Pricing Model is both elegant and relatively simple to calculate.

38

Q6 Discuss the different forms of market efficiency.Answer:

A financial market displays informational efficiency when market prices reflect all available information about value. This definition of efficient market requires answers to two questions: what is all available information & what does it mean to reflect all available information? Different answers to these questions give rise to different versions of market efficiency. What information are we talking about? Information can be information about past prices, information that is public information and information that is private information. Information about past prices refers to the weak form version of market efficiency, information that consists of past prices and all public information refers to the semi-strong version of market efficiency and all information (past prices, all public information and all private information) refers to the strong form version of market efficiency. “Prices reflect all available information” means that all financial transactions which are carried out at market prices, using the available information, are zero NPV activities. The weak form of EMH states that all past prices, volumes and other market statistics (generally referred to as technical analysis) cannot provide any information that would prove useful in predicting future stock price movements. The current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return. It would mean that if the weak form of EMH is correct, then technical analysis is fruitless in generating excess returns. The semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. “Old” information then is already discounted and cannot be used to predict stock price fluctuations. In sum, the semi-strong form suggests that fundamental analysis is also fruitless; knowing what a company generated in terms of earnings and revenues in the past will not help you determine what the stock price will do in the future. This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions. Lastly, the strong form of EMH suggests that stock prices reflect all information, whether it be public (say in SEBI filings) or private (in the minds of the CEO and other insiders). So even with material non-public information, EMH asserts that stock prices cannot be predicted with any accuracy.

39

MF0011– Mergers and Acquisitions

Q.1 What are the basic steps in strategic planning for a merger?Answer:Mergers & Acquisitions are strategic decisions which are taken by the management of any company after thorough examination of many important facts and considerations. Since decisions regarding Mergers & Acquisitions, like capital budgeting decisions are irreversible in nature it is very important that due attention must be paid to some basic issues before planning about it. Hence the strategic planning can be broken down into five steps:

Step 1: Pre Acquisition Review The first step is related with the assessment of company's own situation to determine if a Merger & Acquisition strategy should be implemented or is there any other alternative? If a company expects difficulty in the future when it comes to maintaining growth, core competencies, market share, return on capital, or other key performance variable, then a Merger & Acquisition (M & A) program may be necessary. If a company is undervalued or fails to protect its valuation, it may find itself the target of a merger. Therefore, the pre-acquisition review will include issues like the projected growth rate, inability of the company to sustain its market share in the future because of the potential threat from its competitor firms, under valuation of the company etc. The company must address to a fundamental question. Would the Merger help improve the situation regarding the above or not? Will it affect the valuation in a positive manner?

Step 2: Searching and Screening of the targets The second step in the Merger & Acquisition process is to search for those companies which can be the potential takeover candidates. It is important for the merging company to see whether the company to be acquired has strategic compatibility with the acquiring company or not. Compatibility and fit should be assessed across a range of criteria – size, kind of business, capital structure, core competencies, etc.Searching and screening process should and must be performed by the management of the Acquiring Company without taking the help of any outside agency. Dependence on external firms should be kept minimum however if it is important to take the help of any outside agency.

Step 3: Valuation of the target company The third step in the Merger & Acquisition process is to perform a thorough and detailed analysis of the target company. Acquiring company must confirm that the Target Company is truly a good fit with the acquiring company. This requires a thorough review of operational, strategic, financial, and other aspects of the Target Company. This detail review is called "due diligence." Due diligence is the process of identifying and confirming or disconfirming the business reasons for the proposed capital transaction. Various factors like, customer needs, strategic fit, shareholder value etc is at the core of the analysis. Several functions are involved in due diligence related to potential acquisitions, including strategy, finance, legal, marketing, operations, human resources, and internal audit services. The direction of due diligence efforts depends on what the company expects to gain from the transaction: employees, customers, processes, products, or services. Due Diligence is initiated once a target company has been selected. The main objective is to identify various synergy values that can be realized through an M & A of the Target Company.

40

A key aspect of due diligence is the valuation of the target company. In the preliminary phases of M & A. Total value of the company is calculated keeping in mind the value of the synergy expected from the combination and costs involved in the transaction. An example should give an idea of the calculation involved. Value of Acquiring Company = Rs. 500 lakh Value of Target Company = Rs. 250 lakh Value of Synergies as per Phase I Due Diligence = Rs. 150 lakh M & A Costs = Rs. 60 lakh Total Value of Combined Company = Value of the acquiring company + Value ofthe target company + Value of the Synergy – M & A cost Hence Total value of the combined company = 500 + 250 + 150 – 60 = Rs 840 lakh.

Step 4: Negotiation After selecting the target company it's time to start the process of negotiating. A negotiation plan is developed based on several key questions:

How much resistance Acquiring Company is expected to encounter from the Target Company?

What are the benefits of the Merger for the Target Company? What will be the acquiring company's bidding strategy? How much acquiring company should offer in the first round of bidding?

The most common approach to acquire a company is for both companies to reach an agreement concerning the Merger & Acquisition. The idea is to go for a negotiated merger. The negotiated merger should be the preferred approach to a M & A since when both the company's agree to the deal then there are chances that the process will be a smooth one and will go a long way in making the merger a successful one.

Step 5: Post Merger Integration If everything goes as per planning, the two companies announce an agreement to merge the two companies. This leads to the fifth and final phase within the M & A Process, the integration of the two companies. Every company is different in terms of operations, in terms of structure, in terms of culture, in terms of strategies etc. The Post Merger Integration Phase is the most difficult phase within the M & A Process. It is the responsibility of the management of the two companies to bring the two companies together and make the whole thing work. This requires extensive planning and design throughout the combined organization. If post merger integration is successful, then it should result in the generation of synergy and that is the final objective of any Merger & Acquisition program.

41

Q2 What are the sources of operating synergy?Answer:

Operating synergies are those synergies that allow firms to increase their operating income from existing assets, increase growth or both. Operating synergies can be categorized into four types.

1. Economies of scale: Economies of scale may arise from the merger, allowing the combined firm to become more cost efficient and profitable. Economies of scales can be seen in mergers of firms in the same business (horizontal mergers). For example, two banks combining together to create a larger bank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of cost reducing operating synergy. Both the banks after combination can expect to cut costs considerably on account of sharing of their resources and thus avoiding duplication of facilities available.

2. Greater pricing power: Greater pricing power from reduced competition and higher market share, should result in higher profit margins and operating income. This synergy is also more likely to show up in mergers of firms which are in the same line of business and should be more likely to yield benefits when there are relatively few firms in the business. When there are more firms in the industry ability of firms to exercise relatively higher price reduces and in such a situation the synergy does not seem to work as desired. An example of limiting competition to increase pricing power is the acquisition of Universal luggage by Blow Plast. The two companies were in the same line of business and were in direct competition with each other leading to a severe price war and increased marketing costs. After the acquisition Blow past acquired a strong hold on the market and operated under near monopoly situation. Another example is the acquisition of Tomco by Hindustan Lever.

3. Higher growth: Higher growth in new or existing markets arising from the combination of the two firms. This can be the case, for example, when a firm acquires an emerging market firm with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products.

4. Combination of different functional strengths: Combination of different functional strengths may enhance the revenues of each merger partner thereby enabling each company to expand its revenues. The phenomenon can be understood in cases where one company with an established brand name lends its reputation to a company with upcoming product line or a company. A company with strong distribution network merges with a firm that has products of great potential but is unable to reach the market before its competitors can do so. In other words the two companies should get the advantage of the combination of their complimentary functional strengths. Synergy results from complementary activities. This can be understood with the following examples.

Example Consider a situation where there are two firms A and B. Firm A is having substantial amount of financial resources (having enough surplus cash that can be invested somewhere) while firm B is having profitable investment opportunities ( but is lacking surplus cash). If A and B combine with each other both can utilise each other strengths, for example here A can invest its resource (cash) in the opportunities available to B. Note that this can happen only when the two firms are combined with each other or in other words they must act in a way as if they are one.

42

43

Q3 Explain the process of a leveraged buyout.

Answer:A buyout is a transaction in which a person, group of people, or organization buys a company or a controlling share in the stock of a company. Buyouts great and small occur all over the world on a daily basis. Buyouts can also be negotiated with people or companies on the outside. For example, a large candy company might buy out smaller candy companies with the goal of cornering the market more effectively and purchasing new brands which it can use to increase its customer base. Likewise, a company which makes widgets might decide to buy a company which makes thingamabobs in order to expand its operations, using an establishing company as a base rather than trying to start from scratch. In a leveraged buyout, the company is purchased primarily with borrowed funds. In fact, as much of 90% of the purchase price can be borrowed. This can be a risky decision, as the assets of the company are usually used as collateral, and if the company fails to perform, it can go bankrupt because the people involved in the buyout will not be able to service their debt. Leveraged buyouts wax and wane in popularity depending on economic trends.Four distinct but related stages are envisaged for the proper implementation of LBO programs, which are described below.

1st stage: Arrangement of finance: The first stage of the operation consists raising the cash required for the buy outs and working out a management incentive system. The equity base of the new firm consists of around 10 percent of cash put up by the company's top management or buy out specialists. Outside Investors like merchant bankers, venture capitalists and commercial banks then arrange to provide the remaining equity. Usually 50 per cent of the cash is raised by borrowings against company's assets in secured bank acquisition loans from commercial banks. Rest of the cash is obtained by issuing certain debts in a private placement, usually with pension funds, insurance companies, venture capital firms or public offerings through high-risk high-yield junk bonds. Private placements and and junk bonds are subordinated forms of debts (often referred to as mezzanine money') and they secure a place in between the secured debts from banks and risky residual claims of share holders.

2nd stage: Going private: In this stage, the organizing or sponsoring group purchases all the outstanding shares of the target company and takes it private through stock purchases format or purchase all assets through asset purchasing format. For the latter case, the purchasing group forms another new, privately held corporation. To reduce the debt by paying off a part of bank loans, the new owners sometimes sell off part of the corporation and may begin disposing of the inventory.

3rd stage: Restructuring: In this stage, the new management would try to enhance the generation of profit and cash flows by reducing certain operating costs and changing the marketing strategy. For this operation, it may adopt any or all of the below given policies: viz.

a) Consolidation and reorganization of existing production facilities.b) Changing the product mix (thereby changing the quality of the product) and

changing the policy relating to customer services and pricing. c) Trimming employment through attrition.d) Phasing out employees in turn and reduction on spending on research and

development, new plants and equipments, etc., so long as there is a need toredeem the fresh acquired debts.

44

e) Extraction and implementation of better terms from various suppliers. However, while undertaking the above stated restructuring activities due attention should be given for the approval of genuine capital expenditure programs for the growth of the firm, otherwise, the long term growth of the firm would hamper.

4th stage: Reverse leveraged buyouts: Under this stage, the investor group may take the company to public again, if the already restructured company emerges stronger and the goals set by the LBO groups have already been achieved. This is known as the process of 'Reverse LBO' or the process of 'Going Public', where the process it effected through public equity offerings. The sole purpose of this exercise is to create liquidity for existing shareholders. This type of reverse LBO is executed mostly by ex-post successful LBO companies.

45

Q4 What are the cultural aspects involved in a merger. Give sufficient examples.Answer:

`Companies are joined nearly every day, but often two companies end up weaker together than they were separately. Indeed, a KPMG study showed that 83% of mergers and acquisitions failed to produce any benefits - and over half actually ended up reducing the value of the companies involved. One of the main problems is that mergers and acquisitions are often planned and executed based on perceived cost savings or market synergies; rarely are the “people” and cultural issues considered. Yet, it is the people who decide whether an acquisition or merger works. Customer and employee reactions determine whether the newly combined organization will sink or swim. Before the merger Before the merger takes place, the leaders of both organizations - at least, of the dominant one - should have a strategy mapped out, including communications to employees and customers, where layoffs will take place (if any do), and how the cultures should be merged. A SWOT (strengths, weaknesses, opportunities, and threats) analysis should be done for the combined company. If possible, a brief culture survey (preferably done via interviews as well as paper or Web/e-mail) should be undertaken in both companies to discover what the cultural differences are. Sometimes this will be obvious in some aspects -e.g. one culture values teams and bottom-up innovation, the other favors command-and-control tactics - but not in others, such as how and whether individuals and teams are rewarded for innovations, how failure is dealt with, whether conflict is addressed openly, etc. This will prevent disconcerting delays between the announcement and the implementation of the merger/take over. If the real purpose of the merger is to acquire another company’s assets, in terms of a particular product or brand, its factories or patents, etc., that should be acknowledged and dealt with up front. If employees are fooled at first by pleasant words, they will react more strongly when those words become taunts.

Finally, before the merger or acquisition takes place, the leadership teams should consider the non-financial issues. Will people in the two companies be able to work together? Will acquiring a company, or merging with it, destroy the properties or drive away the talent that made it worth having? Can a simple partnership, alliance, or even stock ownership without integration provide more benefits than combining the two companies? These issues may be overlooked by the leadership teams — just as they are often ignored or downplayed by investment bankers who want to do the deal.

Power relationships In many ways, it makes sense to consider mergers in the same light as acquisitions. It has become a truism that there is no such thing as a merger — one side will come out dominant in each function, even in the friendliest of “mergers.”There can, in the end, only be one CEO, one head of each function, one head of each department. Therefore, we will generally consider mergers and acquisitions to be interchangeable.Power issues should be confronted directly to avoid drawn-out conflicts and confusion for employees. Conflicts must be controlled but addressed, to avoid protracted turf wars, lasting bitterness, and employee withdrawal and retention. (Withdrawal can be psychological as well as physical - employees can simply not go that extra mile, and do the absolute minimum required of them. They can also sabotage change efforts and new initiatives. This can last for many years, long after outsiders have forgotten about the merger.) Personal issues In most takeovers, both companies’ staff lose some productivity (and people) as employees divert their attention to their own place in the future, merged company. Will they still have a job? Will they have advancement prospects? What will be their role? Will the company gain or lose? This is the time when the best employees may jump ship, because they will find it

46

easiest to get jobs elsewhere — which strengthens the competition even as it weakens the integrated company. Mergers can be a profoundly demoralizing time, especially if communications from the leaders are sparse or misleading. Many agree that the best way to handle this is to constantly communicate to everyone in the company, using a variety of methods - face to face included -so that people understand the reasons for the acquisition, the combined companies’ strategy, and how the two companies will combine. If layoffs need to be made, they should be announced quickly and directly, again with the reasons and rationale clearly expressed.As people devote more time to exchanging rumors, trying to find out their status, and dwelling on the change, productivity tends to drop. In the absence of credible, continued information, the grapevine will spread inaccurate rumors with amazing ease. For that reason, the transition should be as short as possible. If there are layoffs, the role and situation of the survivors should be addressed. There is a separate line of research on this, which we will not delve into. As the integration of the company’s proceeds, many may feel that their past ways of working and their contributions are not valued. In addition to celebrating success, the company must show in word and in deed that it value the best of the old ways, the tradition and heritage of the company being taken over. If the new organization shows total disregard for the heritage of groups being taken over, people will take longer to get over the shock of transition, and may sabotage change or simply “vote with their feet.”

Cultural issues Culture - the shared values, beliefs, and preferred ways to behave - is hard to control, and in most mergers, it seems that nobody tries very hard to do it. The end result is that the culture usually is not as productive as it should be in the combined organization, molded primarily by the leader’s actions and politically adept or powerful people in each organization. The goal in a merger is for the better of two companies to be preserved, resulting in synergy and continued profit. This applies to culture as well as to operational processes and technologies. The cultures of each company should be carefully examined, and care taken to guide the combined organization’s culture so it incorporates the best of each. One interesting note on cultural change is that it often seems to come about only when an organization feels that its very survival is threatened. A merger or acquisition provides a fine opportunity for change! The role of organizational development When an OD consultant is brought into the merger/acquisition process, there are a number of roles they can play: Helping the leaders to agree on a clear and specific set of goals for the merger. Setting up measures helps the leadership team to focus on tangible, measurable results, which brings misunderstandings and conflict into the open. Measurement is also an excellent communication tool, since it is an action — which gives the words more credibility. Measuring the results at a number of milestones can also point to potential problems before they become crises, helping to make the merger/acquisition smoother and increasing the likelihood of success. It also helps to keep leaders focused on a balanced set of issues. Scenario planning Will the merger work if there is a market decline? What are the likely responses of customers and regulators? We wonder if, in the Daimler-Benz takeover of Chrysler, anyone considered reactions to Chrysler no longer being an American company, including a loss of sales (since most of its customers are in the United States) and the de-listing from many indexed mutual funds. The 2001 power crises in California were also seen as a result of lack of scenario planning - in this case, testing the assumption that natural gas prices would stay fiat. The OD consultant should not usually lead the scenario planning, but they should be there as a process consultant to ensure that every team member’s contribution is heard, and that people are honest with each other and with themselves. (If that sounds too “touchy-feely,” just think about the plight of the California utilities).

47

Exploring options Are there other ways to accomplish the same goals without a merger? Again, going back to Chrysler, the company was seeking international expansion and financial security. A partnership with Daimler-Benz, or acquiring an Asian or European automaker, would probably have served the company more than becoming a division of a culturally very different conglomerate. Once more, the OD consultant may be most effective as a process consultant rather than as a leader.

Investigating assumptions While usually not a separate exercise, the OD consultant, as an outsider, is in a unique position to bring out hidden assumptions. This should be done continuously throughout the process, though scenario planning and exploring options are expressly designed to explore and test assumptions. Sometimes, brief tactical surveys can be taken to test assumptions; sometimes, questions are enough

Communication Ensuring that a steady stream of information is released by the organization’s leaders; keeping that information balanced, direct, clear, and accurate; and preventing undesirable subtexts from being communicated. The OD consultant should also probe leaders when their words and actions contradict each other, to clarify one or change the other.

Rewards Compensation systems are one thing; intangible rewards are another. Research shows that most people are generally not motivated by money, though they may take a job (or keep a job) for financial reasons. Even where bonuses or profit-sharing help to increase motivation, the money itself is often symbolic, a measuring stick for achievement. The OD professional should help the organization to set up milestones and celebrate small and large successes along the route to integration, so that people not only feel progress, but also feel that their achievements are being rewarded. Otherwise, integration may seem like a long, long road.

Cultural assessment Clarifying each organization’s culture to make the task of integration easier, and to ensure that communications and actions do not accidentally because more harm than good.

Cultural change Working with both organizations to clarify their shared vision of what the culture should be, and then working to make it that way. Johnson & Johnson maintains a shared culture among a large number of companies, some acquired, some home-grown; they do it by having a clear, shared vision and values, and by working with newly acquired firms to ensure that their culture is brought to the J&J way.

Leader coaching To integrate the leadership team, address conflicts, and assure mutual involvement and dedication to the merging process. OD professionals should work at every level of the organization where the merger is taking effect. The goal is to build the ability of the leaders to communicate their intentions accurately, build trust, and manage conflict and tension. Strong leader credibility is key to successful integration. Working with process teams to identify the best practices in each organization and assure that they are not overtaken by less effective standard procedures from the dominant company, but

48

become the standard procedures for both. This includes operational and service processes, but can also be applied to aspects of the culture.

Integrating initiatives One problem that is not unique to mergers and acquisitions is initiative overload, where managers are overwhelmed with not just the merging of two organizations, but also quality initiatives, customer projects, SAP implementation, etc. One of the more challenging projects for an OD professional is integrating initiatives and helping leaders to make tough judgment calls on which ones should be suspended, eliminated, or combined.

Watch key processes Often forgotten in the integration are key processes such as new hire orientation, training, and even compensation systems. These processes all support or sabotage both the present and desired culture. OD professionals understand the role of each organizational system plays in the culture; they must keep an eye on all important systems and processes. By remembering what makes mergers succeed and fail, keeping an eye on the human issues as well as the financials, and using the most appropriate organizational development tools, companies can avoid “bad” mergers — and make the good ones work.

49

Q5 Study a recent merger that you have read about and discuss the synergies that resulted from the merger.Answer:

Below are excerpts from an interesting Harvard Business School Case Study (February 22,2004) providing insight to the scale and value of the HP/Compaq Merger. John Bender’s role as Executive Director of Merger Integration gave him a front-row seat to the largest merger in tech history. “Day-1” of the new HP’s operations are viewed as best-in-class. Successful early integration of two massive IT infrastructures included hp.com (online store) being open for business, @hp employee portal with more than 2 million hits/day accessible to all employees, 1, 193 company networks connected at key strategic locations , active directory and enterprise directory synchronized and all E-mail systems interconnected linking more than 229,000 mailboxes and a quarter million desktops. More than $3.7B in synergies and 95% of integration milestones were achieved in the first 12 months spanning nearly every aspect of the new HP, and focused on key synergy areas of procurement & supply chain, head count reduction, administrative facilities closures, and IT integration. Results easily exceeded Wall Street expectations of $1.4B.Excerpts from “The New HP: The Clean Room and Beyond,” Harvard Business School Case Study, February 22, 2004. In fiscal 2001, HP was the second largest computer company, behind IBM, with pre-merger revenue of $45 billion, 19th on the Fortune 500, with over 88,000 employees in more than 120 countries. However, HP was struggling with difficult economic conditions and a technology industry slump. At the time, Compaq was the third largest computer company, behind IBM and HP, with revenue of $42 billion in fiscal 2001. The company had 66,000 employees in over 200 countries, and was ranked 27th in the Fortune 500. Compaq integration of Tandem and Digital in 1997 and 1998 respectively proved difficult; further pressured by the computer industry’s intense competition, Compaq’s stock took a beating. When Fiorina approached Capellas about a licensing deal, he suggested a broader relationship between HP and Compaq. Capellas felt that there was too much capacity in the industry and that it made sense to consolidate during an economic downturn. The idea of a merger excited Fiorina, who saw it as an opportunity to create a highly competitive technology giant that was well positioned in virtually all of its markets. Historically, mergers within the technology industry had proven difficult, and both HP and Compaq had less than perfect track records with their prior acquisitions. Fiorina, recognizing the multiple obstacles to the merger’s success, had created a dedicated integration team immediately after the merger was announced. The “clean room,” as the integration office came to be known, consisted of pairs of pre-merger HP and pre-merger Compaq employees who were responsible for planning the details of the execution of the merger upon its close. When the merger between HP and Compaq was first announced in early September of 2001(eight months before it was approved), Fiorina and Capellas tapped Webb McKinney of HP and Jeff Clarke of Compaq to run the merger integration team. Together, McKinney and Clarke created a small integration office known as the “clean room” where they could begin planning the details of the merger without violating antitrust laws. The clean room started with a small group of employees but involved almost 2,500 people by the time of the merger’s close. The clean room was responsible for developing a master plan to be implemented upon the merger’s closure; this “road map” was to encompass all aspects of the combined company. The scope of decisions involved in melding the two companies was immense, ranging from larger issues with more strategic impact—such as branding, product lines, and corporate culture—to smaller details, such as cash management systems and financial reporting practices. The integration team was responsible for establishing direction for the newly combined companies, setting priorities, and defining the details of its future operations.

50

Members of the clean room used an “adopt and go” strategy to manage their decision-making process. Category by category, the team reviewed elements of the approaches used by each premerger company, and then–rather than using a hybrid or redesigning each system–selected the best method to use going forward. McKinney noted, “Before the close, we were planning just about every aspect of the launch of the new company and how the new company would integrate. In a sense, it was almost like leading a traditional organization. The only unusual thing was that we were spending most of our time on planning. We could do some prototyping, but that was about it. It was like launching an $80 billion start-up except that the only thing we could do was plan.”Once the merger closed, the clean room couldn’t allow people to think that they could change everything that had been done for the last eight or nine months. It would just slow things down too much. Instead, as the teams form and you get together, your job is to understand and implement the decisions that have been made because speed is the number one thing. HP’s cultural integration team rolled out “Fast Start,” a program designed to ease the transition, explain the new business model, and help define the culture of the newly combined companies. The “Fast Start” workshops were conducted in groups—led by team managers and a facilitator—and were designed to be highly interactive. All 155,000 people in the organization were required to complete the program.

51

Q.6 What are the motives for a joint venture, explain with an example of a joint venture.Answer:

Joint venture, we have all heard of this term one time or another, but what exactly is a joint venture? In lay-man’s terms a joint venture is wherein two or more parties build a relationship, they enter into some agreement to work towards a common goal. Although they have the same goals these parties remain separate and distinct from each other. Joint ventures take place across most industries where companies may combine forces for a specific project but may even be competitors for others. A joint venture is truly a great and proven way to access millions of potential partnerships across countries. Moreover joint venture is indeed a great way to combine efforts, resources, and ideas which will eventually increase sales for both sides of the party. The sales of your online business are more likely to increase with an increase in the number of people you reach through your joint venture effort.If you are an online entrepreneur and you are looking for new strategies to make your business a success, a joint venture may be in the cards and just the thing to create that success. Keep in mind that joint ventures are business partnerships that require cooperation and trust. However, they do not have to be permanent nor does a business owner need to share all his or her secrets to take advantage of a joint venture partnership. Here are some advantages a joint venture brings to your online business: 1. Joint venture enables you to access bigger markets . A strategic joint venture partnership can provide access to larger customer bases and geographical markets. Say for example you are running an online business that specializes in promotional items like shirts, coffee mugs, pens, and other merchandise with company logos. By forming a joint venture with a business consultant who has a wide-range of business contact network, you can supply them with unique promotional items and gain access to a large catalogue mailing list. There is a huge marketing possibility with a joint venture. Since marketing and promotion are always something you need to focus on for your business, getting otherwise inaccessible market taps can help your business grow. 2. Joint ventures give your business longer marketing efforts . The beauty of a joint venture is that not only will it enable you to access a larger market it also gives you a chance to extend your marketing efforts.If you are just starting up your online business then you may not have the budget yet for advertisements, however if you are part of a strategic joint venture you would be able to gain new marketing channels. Additionally, a joint venture strategy may give you more direct access to decision makers. 3. Joint venture gives you access to new resources / technology . Every online entrepreneur dreams of expanding his business with the use of technology. However have you ever thought of rather than trying to obtain venture capital for technology expansion, a joint venture is more appropriate and practical. When you loan money from the back or borrow from someone else, you have the obligation to pay it back before you recognize any considerable profit. But if we use the resources and technology already utilized by a joint venture partner, you could build business and raise revenues faster by sharing the profits. 4. Joint venture gives you access to a bigger and longer prospect list As of the moment how big is your current opt-in list? Is there any way that you can expand and make your list grow? If you have a bigger opt-in list will that mean you get bigger chances of increasing your profits?A joint venture has the ability to broaden and grow your opt-in list in a lot of ways. If you are list leveraging with a partner, then anyone who responds visits your website, or makes a purchase is added to your opt-in list. Doing cross promotions have the same list building capabilities. Say for example you went ahead and posted an ad for your partner in your

52

newsletter and they post an ad for you, then eventually everyone on their list that responds to your ad is now on your opt-in list. 5. Joint ventures promote better customer relationships As an entrepreneur your credibility is important, and in offering your customers a new opportunity, a new product, or a new service with a reputable partner gives you instant credibility. Your customers also see you as someone that thinks about his customers and takes the time and effort to find and present quality opportunities to them. When you offer your customers an excellent product or service, you not only increase your credibility with them, you increase the likelihood that they are going to buy from you again.6. A joint venture presents you with an opportunity to gain capacity and expertise When you enter into a joint venture always remember that you should be able to gain as much from the other company as they can from you. This is one of the biggest advantages of a joint venture that should not be overlooked. 7. When you enter a joint venture any risk that you might get into is shared by you and the other party Since the liability is shared there is less pressure on your part, and likewise the other group as well. Also the flexibility in a joint venture can make your life a lot easier. Like what I have said earlier a joint venture is good for as long as your contract stands. The life span of the agreement can be just enough to cover what you want as a joint venture is not a life time partnership. A joint venture is joining forces for one particular project and not putting two companies together forever and ever.

53

MF0012-Taxation Management

Q1 Tax evasion is a menace to the people, economy and the country. In the wake of recent Swiss bank account scandal give your views on the following:a. How does it affect the Indian economy and the growth prospects?b. Does black money cause Inflation? Answer:

In view of the facts set out so far, it becomes necessary to look at the extent of compliance of tax laws in India. Though many estimates of black money have been coming forth, an attempt was made to determine the extent of tax evasion in the Mumbai Income Tax charge, which collected about 35% of the Income Tax collections of the country and 43% of the corporate tax collections. The study was made on the basis of results of the survey and search cases for all the years covered by such cases. It came to light that none of the tax payers concerned declared for taxation purposes anything more than 25% of their true incomes after 1999. The figure arrived at was given to the press specifying the basis on which it was so calculated. Not a single protest was received from any of the taxpayer, including companies. The said figure was there after cited for some more time, and even thereafter no protest was received. There was, therefore, every reason to believe this estimate. However, there appears to be higher tax evasion in the case of companies. Some of the companies have shown their entire capital saving come from the countries regarded as Tax Havens. Considering the extent of Indian monies stacked in Swiss Bank Accounts, and bank accounts of the developed countries, and comparing the same with the annual income tax collections of the Central Government, it appears that the real income admitted for taxation purposes is less than 25%. The extent of evasion appears to be very much higher in the case of companies as the companies have resorted to evolution of tax evasion devices in the accounts and such methods have not yet been properly investigated by the Income Tax Department. There are companies which have camouflaged their capital investments and shown it in the books as if it is explained capital for income tax purposes.

A. The Indian Scenario – Peculiar problems of tax evasion:

It will be appropriate at this stage to highlight some of the key problems from the viewpoint of computerization in India:

(a) Investments in Real Estate: The one field where black monies have been invested on the largest scale is that of real estate properties. Lands were sold for only 20% of their real values and the balance 80% given in cash out of the tax evaded monies, ever since 1947. But later on when the tax rates were lowered to 30% for individuals’ and 35% for companies, the black portion got reduced to 40%. It may be a difficult task to trace such black transactions through the computer system, suggested for adoption on the U.S. pattern for India. But it is common knowledge that the black monies invested in land have been reinvested in bank accounts, shares and in other properties, apart from real estate property. It is now confirmed knowledge that in regard to buildings constructed, only40% of the cost is shown to income tax. It is possible to detect such investment by analysis of the data obtained from the trade and industry governing commodities used for construction of buildings. Further, as all the transactions relating to sale of real estate properties are now recorded in computers maintained by the Registration Offices all over the country, and if the same data is brought on the computers of the Income Tax Department, it should be possible to know many owners of property who have not filed their tax returns at all so far. In India, there are only 3 corers of tax assesses at present, and thus a large number of people with taxable income have evidently chosen not to file income tax returns.

54

(b) Gold and Jewellery Holdings: India is having the largest private holdings of gold and diamond jewellery among all the countries of the world. In the searches conducted by the Income Tax Department, huge unaccounted cash balances and gold and diamond jewellery have been found in the bank lockers maintained by taxpayer’s in bogus names and in their own names. At current market rates, purchases of gold, silver and diamonds may now reach about Rs. 80,000 crores a year. Gold and diamond trader share mostly keeping their transactions outside bank accounts. They are also giving vouchers to the effect that raw gold has been given by the customers, though; in fact, it would have come from the traders themselves. Therefore, it is necessary to introduce a law requiring them to transact only through bank cheques and issue computerized bills, to facilitate proper flow of information to the computer system of the tax department.

(c) Shares, Mutual Funds, etc: There are vast investments in shares and debentures, travelers’ cheques, mutual funds and the primary bonds issued by the Reserve Bank of India. The data regarding company shares and other investments mentioned can be easily transferred to the computer system of the Income Tax Department. The Mumbai Stock Exchange is having a separate computer system with complete data on daily transactions and the Income Tax Department has so far not made use of such data. There is also the data generated in the computers of the organizations in charge of demat of shares. Like-wise, the data on post office savings and other accounts is easy to be brought on the computers of the tax department for verification with the individual returns, which are available with the Government itself.

(d) Undisclosed Stock in-trade held by companies and traders: Many firms and Individuals have also a tendency to keep undisclosed business assets like cars and private assets, unaccounted cash holdings etc.; they have ability to give extensive bribes to protect business and other interests. All such practices would varnish once fear is caused among the tax payers about the use of computerized data for taxation purposes.

(e) Benami Investments: Benami investments are typical of the Indian economy. Even big companies have indulged in such practices to impart total secrecy to their undisclosed accounts. It may be difficult to determine whether the investment found in the computers of the income tax department is benami or not, and benami shares will have to be traced sometimes by extensive studies to be conducted by teams of revenue officers. This problem requires comprehensive study because it is peculiar to the Indian Taxation System.

(f) Swiss Bank and other undisclosed bank accounts held abroad: Swiss Bank Accounts are shrouded in secrecy and hence no information will be available to the computer system of the Income Tax Department. The amounts in Swiss Bank Accounts, which are held in foreign currency, have been utilized by big companies and other tax payers in India to import huge machineries at vastly under invoiced prices. Such practices enable payment of secret trade commissions in foreign currency and unaccounted funds in Indian currency to those contesting general elections. Several major companies have converted Swiss Account holdings into benami shares and debentures. The large amounts of Swiss Bankdeposits have, thus, been utilized and every year, there are additions to the Swiss Bank Account holdings.

B. Does black money cause Inflation?Illegally earned money is called black money. It is the result of hoarding, smuggling, tax evasion and dealing in immovable property for which the consideration is paid in black. It has been beyond the control of the Government. The black money has already created a

55

serious problem in our country. The Indian economy stands badly shattered because of the huge amount of this tainted wealth lying in the coffers of the rich. It has given rise to parallel economy operating in the country. As a result, the prices continue to raise in spite of all government efforts to control them. The poor go on becoming poorer while the rich go on becoming richer. The gap between the haves and the have notes is widening every day.Black money is used by the rich in various evil activities. They use this money for corrupting and demoralizing social and political life. They display it in ostentatious living and wasteful luxuries. They bribe Government officers and lead them to corruption and dishonesty. They purchase political bosses and control the strings of the Government. Thus the entire social structure comes to be badly polluted. It is difficult to form an exact idea of the amount of black money in circulation in the country. Searches and raids by income Tax authorities are conducted from time to time. Such raids yield crores of rupees. But the people are, at times, cleverer than the Government. They seek the aid of the best legal brains and get the law twisted in their favor. Most of the offenders use all their money and influence and go scot free whenever they are caught. The Government has, at various times, announced some voluntary disclosure schemes for unearthing the black money. These scheme shave proved successful to a very limited extent. What has come to the surface is believed only to be the tip of the huge iceberg lying hidden underneath. The 1997 Voluntary Disclosure Scheme announced by the Government of India unearthed a big amount of black money as the tax rate in this scheme had been reduced to thirty per cent.The black money, according to some reliable estimates has gone up to Rs. 10,000 crores in our country. It is to a great extent responsible for a great rise in prices because the purchasing power of the people has increased. People having black money are leading a life of luxury whereas the poor people are leading a miserable life. Some leading economists of the country have suggested stringent measures to the government to unearth black money but successive governments have been rejecting those measures. The vested interests always stand in the way of effective measures and get them diluted.

The government of the day appears to be doing its best to unearth black money. A number of steps have been taken. Taxation structure and system have been made easier. At different times, the government has brought forward several schemes and asked the people to declare their wealth. There has been some success. A lot soil remains to be done.It must be clear to all that the nation cannot shut her eyes to this state of affairs. Smugglers and black-marketer scan no longer be tolerated. They are striking at the very roots of our democratic structure. All steps to weed the black money out of circulation must be taken as early as possible. The government must come down with a heavy hand on smugglers, tax evaders, black-marketers and hoarders. Black money is a curse. It must be rooted out from public life.

56

Q.2 Detail death cum retirement gratuity under Sec 17(1)iii of IT Act. Is commutation of pension a viable option in terms of tax planning?Answer:

Death-cum-retirement gratuity or any other gratuity which is exempt to the extent specified from inclusion in computing the total income under clause (10) of Section 10. Any death-cum-retirement gratuity received under the revised Pension Rules of the Central Government or, as the case may be, the Central Civil Services (Pension) Rules, 1972, or under any similar scheme applicable to the members of the civil services of the Union or holders of posts connected with defense or of civil posts under the Union (such members or holders being persons not governed by the said Rules) or to the members of the all-India services or to the members of the civil services of a State or holders of civil posts under a State or to the employees of a local authority or any payment of retiring gratuity received under the Pension Code or Regulations applicable to the members of the defense service. Gratuity received in cases other than above on retirement, termination etc is exempt up to the limit as prescribed by the Board.Under the provisions of Section 10(10) of the IT Act, any death-cum-retirement gratuity of a government servant is completely exempt from income tax. However, in respect of private sector employees gratuity received on retirement or on becoming incapacitated or on termination or any gratuity received by his widow, children or dependants on his death is exempt subject to certain conditions. The maximum amount of exemption is Rs. 3,50,000;. Of course, this is further subject to certain other limits like the one half-month's salary for each year of completed service, calculated on the basis of average salary for the 10 months immediately preceding the year in which the gratuity is paid or 20 months' salary as calculated. Thus, the least of these items is exempt from income tax under Section 10(10).Any payment in Commutation of pension received under the Civil Pension(Commutation) Rules of the Central Government or under any similar chime applicable to the members of the civil services of the Union, or holders of civil posts/posts connected with defense, under the Union, or civil posts under a State, or to the members of the All India Services/Defense Services, or, to the employees of a local authority or a corporation established by a Central, State or Provincial Act, is exempt under sub-

(i) of clause (10A) of Section 10. As regards payments in commutation of pension received under any scheme of any other employer, exemption will be governed by the provisions of sub-clause (ii) of clause (10A) of section 10. Also, any payment in commutation of pension received from a Regimental Fund or Non-Public Fund established by the Armed Forces of the Union referred to in Section 10(23AAB)is exempt under sub-clause (iii) of clause (10A) of Section 10. The entire amount of any payment in commutation of pension by a government servant or any payment in commutation of pension from LIC [Get Quote] pension fund is exempt from income tax under Section 10(10A) of IT Act. However, in respect of private sector employees, only the following amount of commuted pension is exempt, namely:(a) Where the employee received any gratuity, the commuted value of one-third of the pension which he is normally entitled to receive; and (b)In any other case, the commuted value of half of such pension. It may be noted here that the monthly pension receivable by a pensioner is liable to full income tax like any other item of salary or income and no standard deduction is now available in respect of pension received by a tax payer.

57

Q.3 Explain the essential conditions to be satisfied by a firm to be assessed as firm under Section 184.Answer:

Position of Firm under the Income Tax Act:Legally, a partnership firm does not have a separate entity from that of the partners constituting the firm as the partners are the owners of the firm. However, a firm is treated as a separate tax entity under the Income Tax Act. Salient features of the assessment of a firm are as under:

1. A firm is treated as a separate tax entity.2. While computing the income of the firm under the head “Profits and gains of business

or profession”, besides the deductions which are allowed u/ss 30 to 37, special deduction is allowed to the firm on account of remuneration to working partners and interest paid to the partners. However, it is subject to certain limits laid down u/s 40(b).

3. Share of profit which a partner receives from the firm(after deduction of remuneration and interest allowable) shall be fully exempt in the hands of the partner. However, only that part of the interest and remuneration which was allowed as a deduction to the firm shall be taxable in the hands of the partners in their individual assessment under the head ‘profits and gains of business or profession.’

4. The firm will be taxed at a flat rate of 30% plus education cess @ 3% plus for the financial year 2010-11.

5. The firm will be assessed as a firm provided conditions mentioned under Section 184 are satisfied. In case these conditions are not satisfied in a particular assessment year, the firm will be assessed as affirm, but no deduction by way of payment of interest, salary, bonus, commission or remuneration, by what ever name called, made to the partner, shall be allowed in computing the income chargeable under the head “profits and gains of business or profession” and such interest, salary, bonus, commission or remuneration shall not be chargeable to income tax in the hands of the partner.

Assessment of firm:From point (5) stated above, it can be concluded that for taxation purposes, a firm can be of two types:Firm assessed as firm (provided conditions mentioned u/s 184 are satisfied).and the firm shall be eligible for deduction on account of interest, salary etc while computing its income under the head business and profession). However, it will be subject to the maximum of the limit specified under Section 40(b)If the prescribed conditions are not satisfied, no deduction shall be allowed to the firm on account of such interest, salary, bonus etc.Essential conditions to be satisfied by a firm to be assessed as firm (Section 184)1. In the first assessment year: The firm will be assessed as a firm, also known as ‘Firm Assessed as Such’ (FAAS) if the following conditions are satisfied:

a) Partnership is evidenced by an instrument i.e. there is a written document giving the terms of partnership.

b) The individual share of the partners is specified in that instrument.c) Certified copy of partnership deed must be filed: A certified copy of the said

instrument of partners.It shall accompany the return of income in respect of the assessment year for which the assessment as a firm is first sought. Where certified copy is not filed with the return there is no provision for condo nation of delay.

58

However where the return itself is filed late then there is no problem if the certified copy is filed along with such return as the condition that it shall accompany the return of income is satisfied. Further Delhi ITAT in the case of Ishar Dass Sahini & Sonsv CIT held that where uncertified Photostat copy of the instrument of partnership is submitted along with the return of income and the certified copy is produced at the time of assessment, it will satisfy this condition.

2. In the subsequent assessment years: If the above three conditions are satisfied the firm will be assessed as such (FAAS) in the first assessment year. Once the firm is assessed as firm for any assessment year, it shall be assessed in the same capacity for every subsequent year if there is no change in the constitution of the firm or the share of the partners. Where any such change had taken place in the previous year, the firm shall furnish a certified copy of the revised instrument of partnership along with the return of income for the assessment year relevant to such previous year. Read the box for some important points to be considered in this regard. Circumstance where the firm will be assessed as a firm but shall not be eligible for deduction on account of interest, salary, bonus, etc. [Section 184(5)]. The firm will be assessed as a firm but shall not be eligible for any deduction on account of interest, salary and bonus etc if there is failure on the part of the firm as is mentioned in Section 144 (relating to Best Judgment Assessment) and where the firm does not comply with the three conditions mentioned under Section 184.

59

Q.4 List out the steps to compute total incomeAnswer:

Step1 – Determination of residential statusThe residential status of a person has to be determined to ascertain which income is to be included in computing the total income. The residential statuses as per the Income-tax Act are shown below–In the case of an individual, the duration for which he is present in India determines his residential status. Basedon the time spent by him, he may be (a) resident and ordinarily resident, (b) resident but not ordinarily resident, or (c) non-resident. The residential status of a person determines the taxability of the income.For e.g., income earned outside India will not be taxable in the hands of a non-resident but will be taxable in case of a resident and ordinarily resident.

Step2 – Classification of income under different headsThe Act prescribes five heads of income. These are shown below–HEADSOFINCOME SALARIES INCOME FROM PROFITS ANDGAINS CAPITAL INCOME HOUSEP ROPERTY OF BUSINESS OR GAINS FROM OTHER PROFESSION SOURCES

These heads of income exhaust all possible types of income that can accrue to or be received by the tax payer. Salary, pension earned is taxable under the head “Salaries”. Rental income is tax able under the head “Income from house property”. Income derived from carrying on any business or profession is taxable under the head “Profits and gains from business or profession”. Pr of it from sale of a capital asset (like land) is taxable under the head “Capital Gains”. The fifth head of income is the residuary head underwhich income taxable under the Act, but not falling under the first four heads, will be taxed. The tax payer has to classify the income earned under there levant head of income.

Step3 – Exclusion of income not chargeable to tax. There are certain incomes which are wholly exempt from income-tax e.g. agricultural income. These incomes have to be excluded and will not form part of Gross Total Income. Also, some incomes are partially exempt from income-tax e.g. House Rent Allowance, Education Allowance. These incomes are excluded only to the extent of the limits specified in the Act. The balance income over and above the prescribed exemption limits would enter computation of total income and have to be classified under the relevant head of income.

Step4 – Computation of income under each head Income is to be computed in accordance with the provisions governing a particular head of income. Undereach head of income, there is a charging section which defines the scope of income chargeable under that head. There are deductions and allowances prescribed under each head of income. For example, while calculating income from house property, municipal taxes and interest on loan are allowed as deduction. Similarly, deductions and allowances are prescribed under other heads of income. These deductions etc. have to be considered before arriving at the net income chargeable under each head

Step5 – Clubbing of income of spouse, minor child etc.In case of individuals, income-tax is levied on a slab system on the total income. The tax system is progressive i.e. as the income increases, the applicable rate of tax increases. Some tax payers in the higher income bracket have a tendency to divert some portion of

60

their income to their spouse, minor child etc. to minimize their tax burden. In order to prevent such tax avoidance, clubbing provisions have been incorporated in the Act, under which income arising to certain persons (like spouse, minor child etc.) have to be included in the income of the person who has diverted his income for the purpose of computing tax liability.

Step6 – Set-off or carry forward and set-off of lossesAn assessed may have different sources of income under the same head of income. He might have profit from one source and loss from the other. For instance, an assesses may have profit from his textile business and loss from his printing business. This loss can beset-off against the profits of textile business to arrive at the net income chargeable under the head “Profits and gains of business or profession”.Similarly, an assesses can have loss under one head of income, say, Income from house property and profits under another head of income, say, Profits and gains of business or profession.There are provisions in the Income-tax Act for allowing inter-head adjustment in certain cases. Further, losses which cannot be set-off in the current year due to inadequacy of eligible profits can be carried forward for set-off in the subsequent years as per the provisions contained in the Act.

Step7 – Computation of Gross Total IncomeThe final figures of income or loss under each head of income, after allowing the deductions, allowances and other adjustments, are then aggregated, after giving effect to the provisions for Clubbing of income and set-off and carry forward of losses, to arrive at the gross total income.

Step8 – Deductions from Gross Total IncomeThere are deductions prescribed from Gross Total Income. These deductions are of three types.

Step9 – Total incomeThe income arrived at, after claiming the above deductions from the Gross Total Income is known as the Total Income. It is also called the Taxable Income. It should be rounded off to the nearest Rs. 10. The process of computation of total income is shown here under–

Step10 – Application of the rates of tax on the total incomeThe rates of tax for the different classes of assesses are prescribed by the Annual Finance Act. Taxation For individuals, HUFs etc., there is a slab rate and basic exemption limit. At present, the basic exemption limit is Rs. 1,00,000 for individuals. This means that no tax is payable by individuals with total income of up to Rs. 1,00,000. Those individuals whose total income is more than Rs. 1,00,000 but less than Rs. 1,50,000 have to pay tax on their total income in excess of Rs. 1,00,000 @ 10% and so on. The highest rate is 30%, which is attracted in respect of income in excess of Rs. 2,50,000. For firms and companies, a flat rate of tax is prescribed. At present, the rate is 30% on the whole of their total income. The tax rates have to be applied on the total income to arrive at the income-tax liability.

Step11 – SurchargeSurcharge is an additional tax payable over and above the income-tax. Surcharge is leviedas a percentage of income-tax. At present, the rate of surcharge for firms and domesticcompanies is 10% and for foreign companies is 2.5%. For individuals, surcharge would be levied @10% only if their total income exceeds Rs. 10 lakhs.

61

Step12 – Education cessThe income tax, as increased by the surcharge, is to be further increased by an additional surcharge called education cess @ 2%. The Education cess on income-tax is for the purpose of providing universalized quality basic education. This is payable by all assesses who are liable to pay income-tax irrespective of their level of total income.

Step13 – Advance tax and tax deducted at sourceAlthough the tax liability of an assesses is determined only at the end of the year, taxis required to be paid in advance in certain installments on the basis of estimated income. In certain cases, tax is required to be deducted at source from the income by the payer at the rates prescribed in the Act. Such deduction should be made either at the time of accrual or at the time of payment, as prescribed by the Act. For example, in the case of salary income, the obligation of the employer to deduct tax at source arises only at the time of payment of salary to the employees. Such tax deducted at source has to be remitted to the credit of the Central Government through any branch of the RBI, SBI or any authorized bank. If any tax is still due on the basis of return of income, after adjusting advance tax and tax deducted at source, the assesses has to pay such tax(called self-assessment tax) at the time of filing of the return Taxation

62

Q.5 Detail the important provisions under Wealth tax Act.Answer:

Wealth tax is not a very important or high revenue tax in view of various exemptions. Wealth tax is a socialistic tax. It is not on income but payable only because a person is wealthy. Wealth tax is payable on net wealth on ‘valuation date’. As per Section 2(q), valuation date is 31st March every year. It is payable by every individual, HUF and company. Tax rate is 1% on amount by which ‘net wealth’ exceeds Rs 30 lakhs from AY 2010-11.(Till 31-3-2009, the limit was Rs 15 lakhs). No surcharge or education cess is payable. No wealth-tax is chargeable in respect of net wealth of any company registered under section 25 of the Companies Act, 1956; any co-operative society; any social club; any political party; and a Mutual fund specified under section 10(23D)of the Income-tax Act [section 45] Net wealth =Value of assets [as defined in section 2(ea] plus deemed assets (as defined in section 4) less exempted assets (as defined in section 5), less debt owed [as defined in section 2(m)]. Debt should have been incurred in relation to the assets which are included in net wealth of assesses. Only debt owed on date of valuation is deductible. In case of residents of India, assets outside India (less corresponding debts) are also liable to wealth tax.In case of non-residents and foreign national, only assets located in India including deemed assets less corresponding debts are liable to wealth tax [section 6].Net wealth in excess of Rs. 30,00,000 is chargeable to wealth-tax @ 1 per cent (on surcharge and education cess).Assessment year –Assessment year means a period of 12 months commencing from the first day of April every year falling immediately after the valuation date[Section 2 (d)] All.).1. Assets:-Assets are defined in Section 2(ea) as follows Guest house, residential house or commercial building –The following are treated as “assets”- (a) Any building or land appurtenant thereto whether used for commercial or residential purposes or for the purpose of guest house (b) A farm house situated within 25 kilometers from the local limits of any municipality (whether known as a municipality, municipal corporation, or by any other name) or a cantonment board[Section 2(ea)(i)]

A residential house is not asset, if it is meant exclusively for residential purposes of employee who is in whole-time employment and the gross annual salary of such employee, officer or director is less than Rs. 5,00,000. Any house (may be residential house or used for commercial purposes) which forms part of stock-in-trade of the assesses is not treated as “asset” .Any house which the assessee may occupy for the purposes of any business or profession carried on by him is not treated as “asset”. A residential property which is let out for a minimum period of 300 days in the previous year is not treated as an “asset”. Any property in the nature of commercial establishments or complex is not treated as an “asset”. Motorcars –Motorcar is an “asset”, but not the following-(a) motor cars used by the assesses in the business of running them on hire (b) motor cars treated as stock-in-trade [Section 2(ea)(ii)]. In the case of a leasing company, motor car is an asset. Jewellery, bullion, utensils of gold, silver, etc.–[Section 2(ea)(iii)]-Jewellery, bullion, furniture, utensils and any other article made wholly or partly of gold, silver, platinum or any other precious metal or any alloy containing one or more of such precious metals are treated as “assets” [Section 2(ea)(ii)]For this purpose, “jewellery” includes ornaments made of gold, silver, platinum or any other precious metal or any alloy containing one or more of such precious metals, and also precious or semi-precious stones, whether or not set in any furniture, utensils or other article or worked or sewn into any wearing apparel. Where any of the above assets (i.e., jewellery, bullion, utensils of gold, etc.) is used by an assesses as stock-in-trade, then such asset is not treated as “assets” under section2 (ea)(iii). Yachts, boats and aircrafts –Yachts, boats and aircrafts (other than those used by the assesses for commercial purposes) are treated as “assets” [Section 2(ea)(iv)] Urban land –Urban land is an “asset” [Section 2(ea)

63

(v)]Urban land means land situated in the area which is comprised within the jurisdiction of a municipality and which has a population of not less than 10,000 according to the last preceding census. Land occupied by any building which has been constructed with the approval of the appropriate authority is not ‘asset’. Any unused land held by the assesses for industrial purposes for a period of 2 years from the date of its acquisition by him is not an asset. Any land held by the assesses as stock-in-trade for a period of 10 years from the date of its acquisition by him is also not an asset.Cash in hand –In case of individual and HUF, cash in hand on the last moment of the valuation date in excess of Rs. 50,000 is an ‘asset’. In case of companies, any amount not recorded in books of account is ‘asset’ [Section 2(ea)(vi)]

2. Deemed assets:-Often, a person transfers his assets in name of others to reduce his liability of Wealth tax. To stop such tax avoidance, provision of deemed asset has been made. In computing theNet wealth of an assesses, the following assets will be included as deemed assets u/s 4.Assets transferred by one spouse to another –The asset is transferred by an individual afterMarch 31, 1956 to his or her spouse, directly or indirectly, without adequate consideration nor not in connection with an agreement to live apart will be ‘deemed asset’ [Section 4(1)(a)(i)]If an asset is transferred by an individual to his/her spouse, under an agreement to live apart, the provisions of section 4(1)(a)(i)are not applicable. The expression “to live apart” is of wider connotation and even the voluntary agreements to live apart will fall within the exceptions of this sub-clause. Assets held by minor child –In computing the net wealth of an individual, there shall be included the value of assets which on the valuation date are held by a minor child(including step child/adopted child but not being a married daughter)of such individual [Section 4(1)(a)(ii)]The net wealth of minor child will be included in the net wealth of that parent whose net wealth [excluding the assets of minor child so includible under section 4(1)] is greater.Assets transferred to a person or an association of persons –An asset transferred by anIndividual after March 31, 1956 to a person or an association of person, directly or indirectly, for the benefit of the transfer or, his or her spouse, otherwise than for adequate consideration, is ‘deemed asset’ of transferor [Section 4(1)(a)(iii)]Assets transferred under revocable transfers –The asset is transferred by an individual to aPerson or an association of person after March 31, 1956, under are vocable transfer is ‘deemed asset’ of transferor [Section 4(1)(a)(iv)] Assets transferred to son’s wife –[Section 4(1)(a)(v)]-The asset transferred by an individual after May 31, 1973, to son’s wife, directly or indirectly, without adequate consideration will be ‘deemed asset’ of transferor [Section 4(1)(a)(iv)] Assets transferred for the benefit of son’s wife –If the asset is transferred by an individual after May 31, 1973, to a person or an association of the immediate or deferred benefit of son’s wife, whether directly or indirectly, without adequate consideration, it will be treated as ‘deemed asset’ of the transferor [Section 4(1)(a)(vi)].Interest of partner –Where the assesses (may or may not be an individual) is a partner in a firm or a member of an association of persons, the value of his interest in the assets of the firm or an association shall be included in the net wealth of the partner/ member. For this purpose, interest of partner/member in the firm or association of persons should be determined in the manner laid down in Schedule III to the Wealth-tax Act[Section 4(1)(b)]. Admission of minor to benefits of the partnership firm-If a minor is admitted to the benefits of partnership in a firm, the value of his interest in the firm shall be included in the net wealth of parent of minor in accordance with the provisions of section 4(1)(a)(ii)[ See Para 546.2]. It will be determined in the manner specified in ScheduleIII. Conversion by an individual of his self-acquired Property in to joint family property –If an individual is a member of a Hindu undivided family and he converts his separate property into property belonging to his Hindu undivided family, or if he transfers his separate property to his Hindu undividedfamily,directlyorindirectly,withoutadequateconsideration, the converted or

64

transferred property shall be deemed to be the property of the individual and the value of such property is includible in his net wealth [Section 4(1A)]If there was such transfer and if the converted or transferred property becomes the subject-matter of a total or a partial partition among the members of the family, the converted or transferred property or any part thereof, which is received by the spouse of the transferor, is deemed to be the asset of the transfer or and is includible in his net wealth. Gifts by book entries –Where a gift of money from one person to another is made by means of entries in the books of account maintained by the person making the gift, or by an individual, or a Hindu undivided family, or a firm or an association of persons, or a body of individuals with whom he has business connection, the value of such gift will be included in the net wealth of the person making the gifts, unless he proves to the satisfaction of the Wealth-tax Officer that the money had actually been delivered to the other person at the time the entries were made [Section 4(5A)] Coparcenaries interest in a Hindu undivided family –If the assesses is a member of a Hindu undivided family, his interest in the family property is totally exempt from tax[Section 5(ii)]. Residential building of a former ruler –The value of any one building used for the residence by a former ruler of a princely State is totally exempt from tax [Section 5(iii)] Former ruler’s jewellery –Jewellery in possession of a former ruler of a princely State, not being his personal property which has been recognized as a heirloom is totally exempt from tax [Section 5(iv)] The jewellery shall be permanently kept in India and shall not be removed outside India except for a purpose and period approved by the Board. Reasonable steps shall be taken for keeping that jewellery substantially in its original shape. Reasonable facilities shall be allowed to any officer of the Government, or authorized by the Board, to examine the jewellery as and when necessary.Assets belonging to the Indian repatriates –Assets(as given below)belonging to assesses who is a person of Indian origin or a citizen of India, who was ordinarily residing in a foreign country and who has returned to India with intention to permanently reside in India, is exempt. A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grand-parents, was born in undivided India. After his return to India, following shall not be chargeable to tax for seven successive assessment years-

a. moneys brought by him into India b. value of asset brought by him into India c. moneys standing to the credit of such person in a Non-resident(External)

Account in any bank in India on the date of his return to India andd. value of assets acquired by him out of money referred to in (a) and (c) above

within one year prior to the date of his return and at any time thereafter [Section 5(v)].

One house or part of a house –In the case of an individual or a Hindu undivided family, a house or a part of house or a plot of land not exceeding 500 sq. meters in area is exempt. A house is qualified for exemption, regardless of the fact whether the house is self-occupied or let out. In case a house is owned by more than one person, exemption is available to each co-owner of the house [Section 5(vi)]

65

Q.6 What is meant by Full value of consideration? How short term capital gains and long term capital gains are computed using full value of consideration?Answer:

Full value of consideration means & includes the whole/ complete sale price or exchange value or compensation including enhanced compensation received in respect of capital asset in transfer. The following points are important to note in relation to full value of consideration.

1. The consideration may be in cash or kind.2. The consideration received in kind is valued at its fair market value.3. It may be received or receivable.4. The consideration must be actual irrespective of its adequacy.

COST OF ACQUISITION –Cost of Acquisition (COA) means any capital expense at the time of acquiring capital asset under transfer ,i.e., to include the purchase price, expenses incurred up to acquiring date in the form of registration, storage etc. expenses incurred on completing transfer. In other words, cost of acquisition of an asset is the value for which it was acquired by the assesses. Expenses of capital nature for completing or acquiring the title are included in the cost of acquisition.

Indexed Cost of Acquisition = COAxCII of Year of transfer_ CII of Year of acquisition

If capital assets were acquired before 1.4.81, the assesses has the option to have either actual cost of acquisition or fair market value as on 1.4.81 as the cost of acquisition. If assesses chooses the value as on 1.4.81 then the indexation will also be done as per the CII of 1981 and not as per the year of acquisition.

COST OFIMPROVEMENT–Cost of improvement is the capital expenditure incurred by an assesses for making any addition or improvement in the capital asset. It also includes any expenditure incurred in protecting or curing the title. In other words, cost of improvement includes all those expenditures, which are incurred to increase the value of the capital asset.

Indexed Cost of improvement = COAxCII of Year of transfer

66

CII of Year of improvementAny cost of improvement incurred before 1st April 1981 is not considered or it is ignored. The reason behind it is that for carrying any improvement in asset before 1st April 1981, asset should have been purchased before 1st April 1981. If asset is purchased before 1st April we consider the fair market value. The fair market value of asset on 1st April 1981 will certainly include the improvement made in the asset.

Provisions for computation of Capital Gain -Provisions under section 48

The income under the head “Capital Gains” shall be computed by deducting the following from the full value of the consideration received or accrued as a result of the transfer of the capital asset :

Expenditure incurred wholly and exclusively in connection with such transfer. The cost of acquisition of the asset and the cost of any improvement thereto.

Computation of Short Term Capital Gains From full value of consideration, deduct Expenditure incurred wholly and in exclusively Cost of acquisition Cost of any improvement of asset

Computation of Long Term Capital Gains From full value of consideration, deduct Expenditure incurred wholly and in exclusively connection with the transfer Indexed cost of acquisition of asset Indexed cost of any improvement of asset

67

MF0013 Internal Audit and Control

Q.1Critically evaluate the qualities of an Auditor in the wake of recent scams

Answer:An auditor renders a professional service to his client. He should not only possess the prescribed statutory qualifications but also certain personal qualities. Some of those personal qualities are mentioned below:

1. Common sense: According to Spicer and Pegler, ”the auditor should have a full share of that most valuable commodity-commonsense.” This is necessary to distinguish between important and not so important information.

2. Independence: Expression of opinion is a prime duty of an auditor. An influenced and biased person cannot form an independent opinion. Hence, independence in true sense is an utmost quality of an auditor.

3. Honesty and Integrity: Like any other professional viz. Doctors, Lawyers etc. auditor should possess a high moral character. In a way, he is a public servant. He must not knowingly, misinterpret any fact or sign any document under undue pressure.

4. Objectivity: Independence of an auditor depends on his ability to act with objectivity. For example, the auditor of XYZ Company believes that closing stock has not been properly valued but accepts a certificate from the management as to its valuation. In this case, the auditors‟ judgment lacks objectivity.

5. Communication: He should be able to communicate effectively, both orally and in writing. Particularly in the matter of report writing, he should be able to convey his message clearly and unambiguously.

6. Tactfulness: He should be firm, yet diplomatic with his client and staff. He should be tactful enough to obtain necessary written as well as oral evidence from his client, so that he can form a reasonable opinion.

7. Awareness of latest developments: An auditor should keep his knowledge up to date related to his audit work likes changes in laws, changes in professional standards, latest development in technical guidelines etc.

68

Q.2What is social audit? Is social audit taken seriously by the corporate world? Give examples of corporates undertaking social audit.

Answer:

The social audit is also called social responsibility audit. A business organization exists in society. Hence, it owes certain responsibilities toward society at large. As Lord Denning has observed: "………… the directors of a great company should owe a duty to those who are employed by the company to see that their conditions of service are proper. They should owe a duty to the customers, to the people to whom the goods are supplied, a public duty perhaps, not to expect excessive prices. They should owe a duty also to the community in which they live, not to make the place of production hideous or a nuisance to those who live around.” Social audit is mainly concerned with social accounting. It may be noted that social accounting is still in early stage and so social audit also.

69

Q.3Explain the Code of Ethics for Internal Auditor. Explain them in context with blacklisting Price Waterhouse Coopers in Satyam Scam.

Answer:

This code of ethics sets the minimum requirements for the performance and conduct of internal auditors. This code applies to all internal auditors but does not supersede or replace the requirement on individual to comply with ethical codes issued by professional institutes of which they are members or student members and any organizational codes of ethics or conduct.” There are four main principles:

1. Integrity: The internal auditor should demonstrate integrity in all aspects of their work. Their integrity establishes an environment of trust, which provides the basis for reliance on all activities carried out by the internal auditors.

2. Objectivity: Objectivity is a state of mind that has regard to all considerations relevant to the activity or process being examined without being unduly influenced by personal interest or the views of others. Internal auditors should display professional objectivity when providing opinions, assessments and recommendations. 3. Confidentiality: Internal auditors must safeguard the information they receive in carrying out their duties. There must not be any unauthorized disclosure of information unless there is a legal or professional requirement to do so.

3. Competency: The internal auditor should make use of his/her knowledge, skills and practical experience necessary for auditor’s activity performance.

They should not accept or perform work that they are not competent to undertake, unless they have received adequate training and support to carry out the work to an appropriate standard. Achieving compliance with code of ethics

1. Security integrity: The internal auditor should: Perform his/her job honestly, diligently and with responsibility. Perform his/her profession in harmony with the acts and other generally binding

regulations. Avoid any illegal activity and performing any activity discrediting the internal

auditor’s profession. Respect the legal and ethical objectives of the organizations. Take care that his/her integrity should not be compromised.

2. Objectivity: The internal auditor should:

Avoid taking part in activities or relations which may damage, or might be understood as damaging his/her unbiased assessment including activities or relations which may be in conflict with public interests.

70

Avoid accepting anything that may damage or might be understood as damaging his/her objective professional assessment.

Protect his/her objectivity against political influence. Disclose all substantial facts known to him/her that being undisclosed might

misrepresent the conclusions on activities or events assessed.

3. Observing Confidentiality: The internal auditor should: Be careful when using and protecting information he/she gathered when auditing. Avoid disclosing and making use of the information obtained during the auditor’s

activities performance in order to damage the interests of other person or organization.

Avoid making use of the information obtained during the auditor’s activities for personal enrichment or in a way which would be in conflict with the law or which would damage legitimate and ethical interests of the organization.

4. Demonstrating Competence: a. It is a pre-requisite that all internal audit staff is aware of and understand:

The organization’s aims objectives, risks and governance arrangements. The purpose, risks and issues affecting the service area to be audited. The terms of reference for the audit assignment so that there is a proper

appreciation of the parameters within which the review be conducted. The relevant legislation and other regulatory arrangement that relate to

the service area to be audited. b. The internal auditor should keep educating himself constantly in order to have a

good command of internal audit techniques and auditor standards necessary for obtaining, examining and evaluating the information.

5. Maintaining Audit Independence: Internal auditors should be independent of the activities they audit. Internal auditors are considered independent when they can carry out their work freely and objectively. Independence permits internal auditors to render the impartial and unbiased judgments essential to the proper conduct of audits. This is achieved through organizational status and objectivity. Independence stands for an internal auditor being able to take a stand and report on materiality issues, uninfluenced by any favors coercion or undue influence.

71

6.

Q.4As a senior audit assistant of M/s. Asutosh Associates, you are in charge of internal audit team of M/s Rajesh Technologies involved in the manufacture of plastic tubes. From the information you obtained you find the company is facing liquidity problem for the last two years. You are required to prepare working paper indicating the internal audit problems you would expect to face and how you plan to overcome them.Answer:

As a senior audit assistant of M/s. Asutosh Associates, I need to prepare working paper indicating the internal audit problems are as follows:Summary of problem area–I. Company is facing liquidity problem due to poor working capital management especially in inventory management area. II.Meerut plant produces all spare parts, whereas Dehradun plan produce less.

PlanningPoints–I. Detailed study of inventory management especially in the area of inventory recording, inventory movement, inventory valuation method, internal control system of inventory etc II. Both the plant i.e. Meerut as well as Dehradun should be visited by audit team. Internal control system should be reviewed by audit team. III. Level of inventory should be verified at both the plants. IV. Various ratio analysis particularly related to inventory should be conducted as compared on month to month basis. Some of the important ratios to be considered are inventory turnover ratio, inventory holding period, raw material inventory turnover ratio, work in progress (WIP) turnover ratio etc. V. Whether the company is following ABC analysis technique to inventory control. In ACB analysis, inventory is categorized according to relative importance for the purpose of monitoring and control. VI. Some of the general problem areas should be specifically checked like :a)The purchase department in order to benefit from the economics of scale indulges in bulk buying, which may cause an overstocking of raw materials.b)The production department’s focuses on output maximization through improved operational efficiency for which un-interrupted production is pre-requisite. Therefore, the production department would always want sufficient inventory of WIP so that interruption at some stage in the production line does not affect its output i.e. finished goods.c)The marketing department with its objectives to maximize sales, would focus on maximizing investment in the finished goods inventory, as it enables the firm to exploit any sudden increase in demand. These individual goals of different departments should be analyze carefully and problem areas should be identified.VII. After completion of internal audit arrange a discussion with management regarding problem areas and suggests them suitable means.

72

Q.5 Explain the use of Sampling technique in Internal audit [SA500]Answer:SA 500: “Audit Evidence“ issued by the Institutes of Chartered Accountant of India says: “The audit evidence should, in total, enable the auditor to form an opinion on the financial information. In forming such an opinion, the auditor does not normally examine all the information that is available to him because he can reach a conclusion about an account balance, class of transactions or a control by way of judgmental or statistical sampling procedures.” Statistical sampling technique is a well accepted audit techniques now-a-days. Statistical sampling in auditing means forming an opinion about a group of items on the basis of examination of a few of the items. Statistical sampling technique add scientific flavor to old, generally accepted by auditing professional, of „test checking‟. Statistical sampling techniques are based on the probability theory. The Institute of Chartered Accountants of India has issued SA 530: “Audit sampling” which is mandatory in nature and applicable to all kinds of audit.” The following is the text of SA 530 modified as per our requirement:

Introduction a. The purpose of this standard is to establish standards on the design and selection

of an audit sample and the evaluation of the sample results. This standard applies to statistical and non-statistical sampling methods. Either method, when properly, applied can provide sufficient appropriate evidence.

b. When using either statistical or non statistical sampling methods, the auditor should design and select an audit sample. Perform audit procedures thereon, and evaluate sample results so as to provide sufficient appropriate audit evidence.

c. Auditing sampling means the application of audit procedure to less than 100% of an item within an account balance or class of transactions to enable the auditor to obtain and evaluate audit evidence about some characteristics of the items selected in order to form or assist in forming a conclusion concerning the population.

d. It is important to recognize that certain testing procedures do not come within the definition of sampling. Tests performed on 100% of the items within a population do not involve sampling, likewise, applying audit procedures to all items within a population which have a particular characteristics (for example all items over a certain amount) does not qualify as audit sampling with respect to the portion of the population examined, nor with regard to the population as a whole, since the items were not selected from the total population on a basis that was expected to be representative.

Design of the sample When designing an audit sample, the auditor should consider the specific audit objectives, the population from which the auditor wishes to sample, and the sample size.

Audit objectives

73

The auditor would first consider the specific audit objectives to be achieved and the audit procedures which are likely to best achieve those objectives. Consideration of the nature of the audit evidence sought and possible error conditions or other characteristics relating to that audit evidence will assist the auditor in defining what constitutes an error and what population to use for sampling. For example, when performing tests of control over an entity’s purchasing procedures, the auditor will be concerned with matters such as whether an invoice was clerically checked and properly approved on the other hand, when performing substantive procedures on invoice processed during the period, the auditor will be concerned with matters such as the proper reflection of the monetary amounts of such invoices in the financial statements.

Population The population is the entire set of data from which the auditor wishes to sample in order to reach a conclusion. The auditor will need to determine that the population from which the sample is drawn is appropriate to the specific objective. For example, if the auditors objective were to test for overstatement of accounts receivable, the population could be defined as the accounts receivable listing, on the other hand, when testing for understatement of accounts payable, the population would not be accounts payable listing, but rather subsequent disbursements, unpaid invoices, suppliers‟ statements, unmatched receiving reports or other populations that would provide audit evidence of understatement of accounts payable. The individual items that make up the population are known as sampling units. The population can be provided into sampling units in a variety of ways, for example, if the auditor’s objectives were to test the validity of accounts receivable, the Sampling unit could be defined as customer balance or individual customer invoices. The auditor defines the sampling unit in order to obtain an efficient and effective sample to achieve the particular audit objectives. Stratification To assist in the efficient and effective design of the sample stratification may be appropriate. Stratification is the process of dividing a population into sub population, each of which is a group of sampling units, which have similar characteristics (often monetary value). The strata need to be explicitly defined so that each sampling unit can belong to only one stratum. This process reduces the variability of the items within each stratum. Stratification therefore, enables the auditor to direct audit efforts towards the items which for example, contain the greatest potential monetary error. For example, the auditor may direct attention to larger value items for accounts receivable to detect overstated material mis-statements. In addition, stratification may result in a smaller sample size.

Sample size When determining the sample size, the auditor should consider sampling risk, the tolerable error, and the expected error.

Sampling risk Sampling risk arises from the possibility that the auditor’s conclusion, based on a sample, may be different from the conclusion that would be reached if the entire population were subjected to the same audit procedure. The auditor is faced with sampling risk in both tests of control and substantive procedures as follows:

a. Tests of Control:

74

Risk of Under Reliance: The risk that, although the sample result does not supports the auditor’s assessment of control risk, the actual compliance rate would support such an assessment.

Risk of Over Reliance: The risk that, although the sample result supports the auditor’s assessment to control risk, the actual compliance rate would not support such an assessment.

b. Substantive Procedures:

Risk of Incorrect Rejection: The risk that, although the sample result supports the conclusion that a recorded account balance or class of transactions is materially mis-stated, in fact it is not materially mis-stated.Risk of Incorrect Acceptance: The risk that, although the sample result supports the conclusion that a recorded account balance or class of transactions is not materially mis-stated, in fact it is materially mis-stated.

The risk of under reliance and the risk of incorrect rejection affect audit efficiency as they would ordinarily lead to additional work being performed by the auditor, or the entity, which would establish that the initial conclusions were incorrect. The risk of over reliance and the risk of incorrect acceptance affect audit effectiveness and are more likely to lead to an erroneous opinion on the financial statements that either the risk of under reliance or the risk of incorrect rejection. Sample size is affected by the level of sampling risk the auditor is willing to accept from the results of the sample. The lower the risk the auditor is willing to accept, the greater the sample size will need to be.

Tolerable error Tolerable error is the maximum error in the population that the auditor would be willing to accept and still concludes that the result from the sample has achieved audit objective. Tolerable error is considered during the planning stage and, for substantive procedures, is related to the auditor‟s judgment about materiality. The smaller the tolerable error, the greater the sample size will need to be. In tests of control, the tolerable error is the maximum rate of deviation from a prescribed control procedure that the auditor would be willing to accept, based on the preliminary assessment of control risk, in substantive procedures, the tolerable error is the maximum monetary error in an account balance or class of transactions that the auditor would be willing to accept so that when the results of all audit procedures are considered, the auditor is able to conclude, with reasonable assurance, that the financial statements are not materially mis-stated.

Expected error If the auditor expects error to be present in the population, a larger sample than when no error is expected ordinarily needs to be examined to conclude that the actual error in the population is not greater than the planned tolerable error. Smaller sample sizes are justified when the population is expected to be error free. In determining the expected error in a population, the auditor would consider such matters as error levels identified in previous audits, changes in the entity’s procedures, and evidence available from other procedures.

Selection of the sample The auditor should select sample items in such a way that the sample can be expected to be representative of the population. This requires that all items in the population have an opportunity of being selected.

75

While there are a number selection methods, three methods commonly used are:

Random selection which ensures that all items in the population have an equal chance of selection, for example by use of random number tables.

Systematic selection, which involves selecting items using a constant interval between selections, the first interval having a random start. The interval might be based on certain number of items (for example, every 20th voucher number) or on monetary totals (for example, every Rs. 1000 increase in the cumulative value of the population). When using systematic selection, the auditor would need to determine that the population is not structured in such a manner that the sampling interval corresponds with a particular patter in the population. For example, if in a population of branch sales, a particular branch’s sales occur only as every 100th item and the sampling interval selected is 50, the result would be that the auditor would have selected all, or none, of the sales of that particular branch.

Haphazard selection, which may be an acceptable alternative to random selection, provided that auditor attempts to draw a representative sample from the entire population with no intention to either include or exclude specific units. When the auditor uses this method, care needs to be taken to guard against making a selection that is biased, for example, towards items which are easily located, as they may not be representative.

Evaluation of sample results Having carried out, on each sample item, those audit procedures that are appropriate to the particular audit objective, the auditor should:

1. Analyze any errors detected in the sample. 2. Project the errors found in the sample. 3. Reassess the sampling risk.

Analyze of errors in the sample In analyzing the errors detected in the sample, the auditor will first need to determine that an item in question is in fact an error. In designing that sample, the auditor will have defined those conditions that constitute an error by reference to the audit objectives. For example, in a substantive procedure relating to the recording of accounts receivable, a misposting between customer accounts does not affect the total accounts receivable. Therefore, it may be inappropriate to consider this an error is evaluating the sample results of this particular procedure, even though it may have an effect on other areas of the audit such as the assessment of doubtful accounts. When the expected audit evidence regarding a specific sample item cannot be obtained, the auditor may be able to obtain sufficient appropriate audit evidence through performing alternative procedures. For example, if a positive account receivable confirmation has been requested and no reply was received, the auditor may be able to obtain sufficient appropriate audit evidence that eh receivables is valid by reviewing subsequent payments from the customer. If the auditor does not, or is unable to perform satisfactory alternative procedures, or if the procedures performed do not enable the auditor to obtain sufficient appropriate audit evidence the item would be treated as an error. The auditor would also consider the qualitative aspects of the errors. These include the nature and cause of the error and the possible effect of the error on other phase of the audit. In analyzing the errors discovered, the auditor may observe that many have a common feature, for example, type for transaction, location, product line, or period of time. In such circumstances, the auditor may decide to identify all items in the population which possess

76

the common feature, thereby producing a sub-population, and extent audit procedures in this area. The auditor would than perform a separate analysis based on the items examined for each sub population. Projection of errors The auditor projects the error results of the sample to the population from which the sample was selected. There are several acceptable methods of projecting error results. However, in all the cases, the method of projection will need to be consistent with the method used to select the sampling unit. When projecting error results, the auditor needs to keep in mind the qualitative aspects of the errors found. When the population has been divided into sub-population, the projection of errors is done separately for each sub-population and the results are combined. Reassessing sampling risk The auditor needs to consider whether errors in the population might exceed the tolerable error. To accomplish this, the auditor compares the projected population error to the tolerable error taking into account the results of other audit procedures relevant to the specific control or financial statement assertion. The projected population error used for this comparison in the case of substantive procedures is net of adjustments made by the entity. When the projected error exceeds tolerable error, the auditor reassesses the sampling risk and if that risk is unacceptable, would consider extending the audit procedure or performing alternative audit procedures.

Effective date This statement on Standard Auditing Practices becomes operative for all audits relating to accounting periods beginning on or after April 1, 1998.

77

Q.6 What factors influence the internal control environment? Give examples for each factor.Answer:

The environment in which internal control operates has an impact on the effectiveness of the specific control procedures. A strong control environment, for example, one with tight budgetary controls and an effective internal audit function, can significantly complement specific control procedures. However, a strong environment does not, by itself, ensure the effectiveness of the overall system of internal control. The system of internal control must be under continuing supervision by management to determine that it is functioning as prescribed and is modified as appropriate for changes in conditions. The whole internal control environment may change from those in a manual setting. The nature of the audit evidence changes when information is a manual setting. The nature of the audit evidence changes when information is readable only by electronic means. The use of computer assisted audit techniques may result in the performance of audit tests by the computer which were previously done manually. In addition, these techniques may enable the auditor to carry out audit procedures that were hither to impracticable. As new systems are acquired or developed he can determine whether data can be accumulated and stored in a manner that will facilitate later audit. Through maximum utilization of computer assisted audit techniques, the internal auditor may not only improve the quality of audits, but also sharpen his capabilities to perform special reviews for management thus provide better service. The internal control environment may be affected by: a)Organizational Structures: The organizational structure of an entity serves as a framework for the direction and control of its activities. An effective’s structure provides for the communication of the delegation of authority and the scope of responsibilities. It should be designed, in so far as practicable, to preclude an individual from overriding the control system and should provide for the segregation of incompatible functions. Functions are incompatible if their combination may permit the commitment of concealment of fraud or error. Functions that typically are segregated are access to assets, authorization of transactions, execution here of, and record-keeping. b)Management Supervision: Management is responsible for devising and maintaining the system of internal control. In carrying out its supervisory responsibility, management should review the adequacy of internal control on a regular basis to ensure that all significant controls are operating effectively. When an entity has an internal audit system, management may entrust to it some of its supervisor functions, especially with respect to the review of internal control. c)Personnel: The proper functioning of any system depends on the competence and integrity of those operating it. The qualifications, selection and training as well as the personal characteristics of the personnel involved are important features in establishing and maintaining a system of internal control.

78