1.27 Query: Accounting for loss incurred on the sale of non-convertible debentures, having detachable warrants with a right to subscribe for equity shares attached therewith.
1. A company registered under the Companies Act, 1956, carries on activities of manufacturing of chemical fertilizers, caprolactam, nylon-6, melamine, argon gas, etc. It is one of the promoters of another company ‘X’ and holds 2,22,50,000 equity shares of Rs. 10/- each, fully paid up in this company. The accounting year of the company ends on 31st March, every year. 1. 2. The company had applied for 15.5% secured redeemable non-convertible debentures of Rs. 40 each for cash at par attached with detachable warrants, issued by ‘X’, carrying entitlement to subscribe for one equity share for each detachable warrant. The debentures were offered on right basis in the ratio of one debenture for every three equity shares of Rs. 10 each held by the existing shareholders. Each debenture was of the face value of Rs. 40/- and had one detachable warrant attached therewith, which entitled the original holder of the right to subscribe to one equity share of Rs.10/- at premium not exceeding Rs. 25/- on the expiry of 12 months from the date of allotment of debenture. It is the condition of the issue that the detachable warrant will be issued only when the debentures are fully paid-up.
3. In terms of the offer letter of the debentures (copy of which has been supplied by the querist for perusal of the Committee) the payment towards application money was to be made @ Rs. 8/- and the balance amount (Rs. 32/-) was to be paid on allotment. The debenture carried interest @ 15.5%, payable annually. The debentures were to be redeemed in three equal instalments at the end of 7th, 8th and 9th year. For the convenience of the shareholders, ‘X’ had made an arrangement to buy-back the non-convertible debentures. The buy-back amount will be Rs. 32/- per debenture (inclusive of accrued interest, if any). In other words, the debenture holder exercising the option of buy-back will have to pay Rs.8/- by way of discount charge. However, he has the entitlement to make application for purchase of equity share at premium of Rs. 25/- by surrendering the detachable warrants, after the expiry of 12 months from the date of allotment of debentures. At present, ‘X’s shares are being quoted in the stock exchange at Rs. 60/- per share and by exercising the option, the holder of detachable warrants would get the share at Rs. 43/- (inclusive of discount charge of Rs.8/- paid earlier on surrendering the non-convertible debentures and retaining the right to subscribe for equity share). The detachable warrants will be listed for trading on various stock exchanges along with the debentures. During the year 1992-93, the company had subscribed debentures by paying the application money of Rs. 8/- per debenture and before payment of allotment money, surrendered the debentures to the financial institution after retaining the right to hold the detachable warrants.
4. According to the querist, if the selling of non-convertible debentures to the financial institution and allotment of shares against detachable warrants occur in same accounting year, the position would be as under:
(i) If the detachable warrants are sold in the market, net profit/loss would be net of (a) loss of Rs. 8/- on surrendering non-convertible debentures, and (b) profit /loss on selling detachable warrants.
(ii) If equity shares are subscribed against detachable warrants, the cost of shares to the company would be Rs. 43/- (Rs. 35 inclusive of premium of Rs. 25 + loss of Rs.8/- on surrendering non-convertible debentures).
However, in the instant case, the selling of non-convertible debentures and subscribing to the equity shares of ‘X’ against detachable warrants will occur indifferent accounting years, i.e., selling of non-convertible debentures in 1992-93 and exercising of option of subscribing to shares against detachable warrants/sale of detachable warrants in 1993-94. 5. Arising from the above facts, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
(i) Can the loss of Rs. 8/- incurred on selling of non-convertible debentures be carried forward as cost of detachable warrants and treated as cost of equity shares that may be subscribed against detachable warrants in the subsequent year?
(ii) Is it obligatory for the company to write-off the loss of Rs.8/- in the accounting year 1992-93 itself pending right to subscribe to equity shares against detachable warrants in 1993-94?
(iii) Can the company carry forward the loss of Rs. 8/- to 1993-94, considering it was a part of the cost of detachable warrants and subsequently add it to the cost of equity shares to be subscribed against detachable warrants?
(iv) How should the detachable warrants on hand be disclosed in the Balance Sheet for the year 1992-93? Should these be shown under ‘Investments’ as detachable warrants with a right to subscribe to equity shares of ‘X’ with adequate disclosure by way of note, or as ‘miscellaneous expenditure’ to the extent not written off or adjusted? What should be the mode of valuation? At cost or book value?
(v) In case the company can carry forward loss of Rs. 8/- in 1993-94, can the same be set-off against the profit that may arise if the company decides to sell the detachable warrants instead of subscribing to equity shares?
(vi) Insofar as the income-tax assessment of the querist for the financial year 1992-93 is concerned, how the loss of Rs. 8/- per debenture will be treated? Whether this will be treated as a short-term loss in the year of sale or the purchase price/cost towards the right to acquire shares at a future date, treating thereby this loss as a part of the investment (capital expenditure) cost. In the income-tax assessment of the next financial year, i.e., 1993-94 when the detachable warrants or the equity shares (if subscribed) are sold in the market, whether the profit made on the sale of such shares can be adjusted against the loss incurred in discounting the debenture in the earlier year.
Opinion July 15, 1993
1. The Committee notes that non-convertible debentures (NCDs) with a right to receive detachable warrants that will enable the holder to subscribe for equity shares at a future date has two distinct constituents, i.e., an NCD and a detachable warrant. Both the debenture and the warrant can be sold in the market/transferred, independently of each other. Therefore, in the view of the Committee, at the time of acquisition of the debentures both constituents should be recognised and accounted for separately according to their particular characteristics, and having regard to the true economic effect of the transaction taken as a whole. However, the sum of the values assigned to both the constituents on initial recognition should not exceed the cost of the instrument as a whole (Rs. 40 in the present case). That is, there shall not arise any gain or loss from separation of a composite instrument into its constituent parts.
2. The Committee further notes that the company has the option to retain NCD still their maturity, in which case these will be repaid at par value, or sell it in the open market or surrender it to the financial institution at an agreed price.
3. In the view of the Committee, normally the value to be assigned to NCDs and detachable warrants, at the time of initial recognition of these instruments will depend on many factors, e.g., whether the cost or value of the instrument to the company can be measured reliably, their fair value, market value, intention of the management in applying for NCDs, i.e., whether the company applied for NCDs only for subsequently acquiring equity shares or otherwise, etc.
4. The Committee is of the view, in the light of the facts and circumstances of the given case, that although apparently the company has applied for NCDs only, in substance the consideration paid is for the both NCDs and the warrants. Therefore, the company may recognise, on allotment of NCDs, the detachable warrants, or the right to receive the same for that matter, at Rs.8 and NCDs at Rs. NIL, presuming the acquisition of detachable warrants was a prime consideration in applying for NCDs. Any subsequent cost incurred in relation to, or profit or loss arising on sale/transfer of NCDs or the warrants shall be treated as independent transactions and accounted for accordingly. Also, when the warrants are exchanged for equity shares, their book value should be considered as a part of the cost of the shares so acquired.
5. As per Rule 2 of Advisory Service Rules of the Expert Advisory Committee , the Committee does not answer the queries relating to taxation matters involving only interpretation of law.
6. On the basis of the above, and the facts and circumstances of the query, the Committee is of the following opinion in respect of the issues raised by the querist at para 5 of the query:
(i) The company should recognise detachable warrants, at the time of allotment of the debentures, at Rs. 8 each, as suggested at para 4 above. The value of the warrants so recognised should be carried forward as their cost and be adjusted in the cost of equity shares, if any, received against them.
(ii) In view of para 4 above, there will not arise any loss to the company. Therefore, this question does not arise.
(iii) Yes, the company should carry Rs. 8 as cost of each warrant and subsequently add it to the cost of equity share to be subscribed against it.
(iv) The detachable warrants should be shown under the head ‘Investments’ with adequate disclosures by way of a note. The valuation of the warrants will depend on whether the company intends to acquire shares against them or otherwise dispose them of. In case the company intends to acquire shares against them, it will be in the nature of an investment and shall normally be valued at cost, i.e., Rs. 8, whereas, in the latter case these should be valued at the lower of cost and market value as on the date of the balance sheet.
(v) Rs. 8 can be carried forward as the cost of detachable warrants. On sale of these warrants, the cost should be adjusted against sale proceeds.
(vi) No opinion in view of 4 above. ___________________________________ |