A Comprehensive Guide to Chit Funds: Mechanisms and Regulations

Understanding Chit Funds: A Comprehensive Overview

A chit fund is a unique investment mechanism where members collaboratively contribute a pre-agreed sum into a common fund. Subsequently, the member who bids the lowest discount receives the total amount collected, known as the "pot."

How Are Chit Winners Selected?

Winners in a chit fund can be determined using one of the following methods:

Auction
Lottery

Operational Mechanics of Chit Funds

Each chit fund scheme comprises a fixed number of subscribers, with the scheme's duration matching the number of subscribers. For example, if there are 12 subscribers, the scheme will run for 12 months, with the organizing company also being considered a subscriber.

Illustrative Example

Consider a chit fund with 30 members, each contributing Rs. 10,000 monthly. This generates a corpus of Rs. 300,000 in the first month, referred to as the pot. Members bid on this pot, with the highest discount bidding member entitled to the prize money. If a member bids for Rs. 210,000, the remaining Rs. 90,000 becomes the discount amount. This discount represents a loss for the member receiving Rs. 210,000 and a profit for others. The organizer retains a commission—assuming a 5% fee on the entire amount, which amounts to Rs. 15,000. The rest, Rs. 75,000, is distributed equally among all members, resulting in each member receiving a profit of Rs. 2,500 on their Rs. 10,000 investment.

Regulatory Authority Governing Chit Funds in India

Chit finances in India are governed by the Chit Funds Act, 1982, applicable throughout India, excluding Jammu and Kashmir. Key provisions include:

Chit funds must secure prior state government approval before operation.
Such sanction lapses if the chit is not registered within 12 months or within an extension of no more than six months granted by the state government.
Applications for sanction are to be submitted by the foreman.
Any public solicitation for subscriptions must include a statement confirming that required sanctions have been obtained.

Chit Agreements

Requirement for Chit Agreements

Every chit agreement must:

Be executed in duplicate and signed by all subscribers or their authorized representatives, along with the foreman, and attested by at least two witnesses.
Not extend beyond five years unless the state government permits a longer duration, not exceeding ten years.
Limit the discount to no more than 30% of the chit amount.

Filing Procedures

Each chit agreement must be filed by the foreman in duplicate with the registrar. The registrar keeps one copy and returns the other endorsed, confirming registration under the Act.

Continuation Provisions

If a foreman passes away, becomes incapacitated, or is adjudicated insolvent, the chit may proceed in line with the chit agreement. Subscribers can appoint one or more authorized individuals to take over the foreman's duties if necessary.

Termination Conditions of a Chit Fund

A chit fund may be considered terminated under the following circumstances:

Upon expiry of the specified duration in the chit agreement, provided all dues are settled.
With written consent from all non-prized and unpaid prized subscribers and the foreman, along with a filed copy of the consent with the registrar.
In the event of the foreman's death or incapacity, and failure to continue per the chit agreement.

Winding Up Procedure

The registrar can initiate winding up of a chit fund based on various reasons including:

The chit termination as per clause (c) of Section 40.
Actions by the foreman that impair the security.
Failure to deposit necessary amounts as required by the Act.
Evidence of the foreman's inability to meet financial obligations or fraudulent activities.

Exemptions from the Act

The Act does not apply to:

Any chit initiated before its enactment.
Chits with an aggregate amount not exceeding Rs. 100.

Banks are also prohibited from conducting chit business post the commencement of this Act.

Key Takeaways

Companies must have a minimum paid-up capital of Rs. 1 lakh to start chit business.
Chit business operators must include "chit," "chit fund," "chitty," or "kuri" in their business name.
A reserve fund must be established and maintained by chit fund companies, with at least 10% of annual profits allocated to it.
Chit operators cannot conduct other businesses without explicit approval from the state government.
Different limitations apply based on whether the foreman is a firm, individual, or cooperative regarding aggregate chit amounts.
Accurate record-keeping is essential, with inspection rights granted to the registrar or authorized officers.

Tax Implications of Chit Funds

Dividends remain non-taxable and not tax-deductible.
Overall losses from chit funds are recognized as business expenditures per Section 37.
Overall gains are taxed as income from other sources.

Accounting Treatment of Chit Funds in India

The accounting treatment of chit funds adheres to guidelines established in the Chit Funds Act, 1982, and accepted accounting practices.

Example of Accounting Entries

Initial Contributions: When members contribute to the fund, it is recorded as a liability:
- Journal Entry:
  - Chit Fund Liability: Rs. 2,00,000
  - Cash/Bank: Rs. 2,00,000
Auction/Draw Process: When a member wins the draw, the amount is considered an expense:
- Journal Entry:
  - Chit Fund Expense: Rs. 15,000
  - Cash/Bank: Rs. 15,000
Commission Income: Commissions collected are recognized when earned:
- Journal Entry:
  - Commission Income: Rs. 10,000
  - Chit Fund Liability: Rs. 10,000
Handling Defaults: Defaults on contributions may be written off:
- Journal Entry:
  - Bad Debt Expense: Rs. 10,000
  - Chit Fund Liability: Rs. 10,000
Final Distribution: Upon concluding the fund, adjust liabilities for distribution:
- Journal Entry:
  - Chit Fund Liability: Rs. 1,80,000
  - Cash/Bank: Rs. 1,80,000

These entries illustrate a simplified approach to accounting for chit funds. It is essential to maintain thorough records, comply with the Chit Funds Act, and consult accounting professionals to ensure adherence to regulations.