1.37 Query: Accounting for Contingent liabilities
1. A closely held public limited company is engaged in manufacturing steel pipes. Because of operational losses suffered initially, the company became sick. The matter of rehabilitation of the company was referred to the Board for Industrial and Financial Reconstruction (BIFR). The Board, in its order dated 8-3-1988, opined that it was not possible to revive the unit and as such the company be wound up. The company aggrieved by the order took up the matter with the Appellant Authority for Industrial Financial Reconstruction (AAIFR). The authority in its order dated 17-12-1990 passed the scheme of rehabilitation. The relevant extracts of the order are reproduced hereinbelow:
“(a) The entire case credit account should be treated as irregular. Allahabad Bank (AB) and Vijaya Bank (VB) would waive the penal interest. Out of the balance outstanding dues, the principal portion should be serviced in full in 10 years period and the remaining amount should be bifurcated into two parts, i.e., (i) funded interest at zero rate payable within 10 years, and (ii) zero based debentures, below the line, repayable after 10 years. The above bifurcation should be made keeping in view the servicing capacity of the unit. The above zero based debentures below the line would not appear in the balance sheet of the company but will be shown in notes forming part of accounts as ‘contingent liabilities’.
(b) IRBI & PICUP would waive compound interest/penal interest, charged into the account upto 31-12-90, if any. The principal and simple interest as on 31-12-88, should be paid within 10 years, the simple interest being free of interest. The simple interest of PICUP & IRBI accrued between 1-1-89 to 31-12-90 be kept in interest free frozen account zero based secured debenture, above the line, which should be paid after 10 years.”
2. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) What is the concept of issuing ‘zero based debentures’ above the line and below the line and how they are to be treated in the books of account of the company?
(b) The order says “The zero based debentures below the line would not appear in the balance sheet of the company but will be shown in notes forming part of accounts as contingent liabilities”. These debentures are repayable after ten years. What accounting treatment will be required when the said contingent liability becomes a specific liability after a period of ten years?
(c) What type of disclosures will be required in the auditors’ report on the accounts of the company in which above accounting treatment is carried out?
Opinion January 20, 1993
1. The Committee notes that the terms ‘zero based debentures, above the line’ and ‘zero based debentures, below the line’ are not normally used in accounting terminology. Here, in the view of the Committee, the expression ‘zero based debentures, above the line’ has been used to refer to a specific liability of the company, to be shown in its balance sheet. The expression ‘zero based debentures, below the line’, has been used to refer to a contingent liabilitiy, to be shown as a part of the notes to the account.
2. The Committee notes the term ‘Contingency’ has been defined in para 3.1 of Accounting Standard (AS) 4 on ‘Contingencies and Events Occurring After the Balance Sheet Date’, issued by the Institute of Chartered Accountants on India, to mean “…… a condition or situation, the ultimate outcome of which, gain or loss, will be known or determined only on the occurrence or non-occurrence of one or more uncertain future events.”
3. In the view of the Committee, from the facts of the query, apparently, repayment of the debentures, required to be shown as a contingent liability, is subject to the revival of the company. Because, had the intention been to make it an unqualified liability, repayable in future irrespective of the financial condition of the company at that point of time, the Authority might not have bifurcated the interest liability into two parts, i.e., one specific and the other contingent liability, in the first place itself. It may well have provided for the issue of debentures repayable any time, say 15 or 20 years, after expiry of ten years, for this part of the interest liability also. Hence, the said debentures are a contingent liability, settlement of which would depend upon the revival of the company, which is an uncertain event and would be determined in future only.
4. On the basis of the above, the Committee is of the following opinion, in respect of the issues raised in para 2 of the query:
(a) Zero based debentures, issued in lieu of funded interest (which is a part of the existing liability) is a present liability of the company and should be shown as such in the balance sheet of the company. Zero based debentures issued as a contingent liability are in the nature of a guarantee provided by the company. The company should disclose the amount and the nature of this liability, indicating the fact that it is represented by the debentures issued, in notes to the accounts, until this becomes a specific liability.
(b) When the liability on account of the said zero based debentures, issued as a guarantee, crystallizes after the expiry of ten years, the liability so arising should be brought into the books of account through the following entry (presuming that originally the relevant liability was written back through the profit and loss account.):
Loss on issue of new debentures …..Dr
To Zero based debentures account
The loss on account of issue of debentures should be written off to profit and loss account.
(c) No comment need be given in the report of the auditors of the company in this regard, if the accounting treatment as suggested above is followed and effects of the same are disclosed in the financial statements in an appropriate manner. _____________________________
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