1.15 Query:           

Accounting of renunciation of right shares.

1. A public limited company, which is a wholly owned Central Government public sector undertaking, is engaged in the manufacture and sale of lamps, dairy machinery, machine tools, watches, tractors, printing machines, presses etc.

2.In the year 1974, the company invested in 85,000 equity shares of Rs. 10 each, fully paid-up, in PTL. These were part of the company’s long-term trade investments in as much as it was a manufacturer of tractors and by virtue of the shareholding, it was entitled to nominate an executive on the Board of PTL. This investment is classified under the head “Investments” in the company’s balance sheet and is carried at cost. The current market value is around Rs. 220 per share.

3.During the financial year 1990-91, PTL made an offer of right to the existing shareholders in the ratio of one right share for every two equity shares held. Accordingly, by virtue of the company’s holding of 1,19,000 equity shares (including 34,000 bonus shares issued earlier), it was offered 59,500 equity shares on right basis at a premium of Rs. 60 per share (i.e., a subscription price of Rs. 70 for each equity share of Rs. 10 par value).

4.The company’s Board decided not to take up the rights but to renounce the same. Offers were invited from leading merchant bankers and the rights were renounced in favour of SBI Capital Markets Ltd. at a price of Rs. 55 per right, i.e., an aggregate amount of Rs. 32,72,500 was received by the company towards the transfer.

5.The company is of the view that the amount realised on renunciation of rights does not go to reduce the original cost of investment nor is it in the nature of a capital receipt. It may correctly be taken to the profit and loss account as a revenue item of the year. On the other hand, the auditors are of the view that the amount received on renunciation of rights is a capital receipt and has to be carried to Capital Reserve Account.

6.The querist has submitted that the right to subscribe to additional equity shares at a pre-determined price fixed by the company has arisen during the financial year 1990-91 after the rights issue was approved by the shareholders of PTL in a general meeting. The subscription rights offered has relation to the existing shareholding only for the purpose of determining the number of rights shares which the company is entitled to subscribe to. The property in rights do not arise per se from the original investment. The renunciation of rights in favour of a third party tantamounts to the renunciation of the company’s right to invest in the equity shares of PTL. The amount received on the renunciation of such a right is in the nature of a trading receipt and can be correctly taken to the year’s revenue. It is not a capital receipt in as much as the amount has not been received on the transfer of a capital asset.

7.The querist has sought the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India on the following issues:

(i) Whether the amount realised on the renunciation of rights can be taken to the Profit and Loss Account as an item of revenue;

 

(ii) If the answer to (i) above is in the negative and amount is to be considered as an time of Capital Reserve, whether any write-offs in relation to loss in the value of other investments may be adjusted against the Capital Reserve.

                                                             Opinion                                                       June 7, 1991

1. The Committee notes paragraph 4.20 of Statement on Auditing Practices, issued by the Institute of Chartered Accountants of India, which states as under:              

“Right Shares

 

“4.20 When right shares offered are subscribed for, the cost of the right shares is added to the value of the original holding. If rights are not subscribed for but are sold in the market, the resulting profit is a capital gain which may be taken to the profit and loss account if the Memorandum and Articles of the company do not prohibit it. In certain circumstances (i.e., where the market value of the original holding has fallen below its cost) it may be appropriate to apply the sale proceeds of the rights to reduce the cost of the original holding.”

2.The Committee also notes paragraphs 3.2 and 10 of Accounting Standard (AS) 5 on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’ which are reproduced below:

“3.2 “Extraordinary items” are gains or losses which arise from events or transactions that are distinct from the ordinary activities of the business and which are both material * and expected not to recur frequently or regularly. These would also include material adjustments necessitated by circumstances, which though related to previous periods are determined in the current period.

 

10. Extraordinary items of the enterprise during the period should be disclosed in the statement of profit and loss as part of net income. The nature and amount of each such item should be separately disclosed in a manner that their relative significance and effect on the current operating results of the period can be perceived.”

 

3. The Committee is of the view that if, in the present case, the market value of the original holding has not fallen below cost, it will not be proper to apply the sale proceeds of rights to reduce the cost of original holding. The Committee is of the view that the amount received on renunciation of rights may be taken to profit and loss account if the Memorandum and Articles of Association of the company do not prohibit it.

4.The Committee is accordingly of the opinion that the amount received on renunciation of rights may be taken to profit and loss account if the Memorandum and Articles of Association of the company do not prohibit it and the market value of original holding has not fallen below cost. The said amount should be shown as an extraordinary item as recommended in para 10 of AS 5 reproduced above.

_________________________

* Material items have been defined in the Accounting Standard on “Disclosure of Accounting Policies” (AS-1) as items the knowledge of which might influence the decisions of the users of the financial statements.