A. Facts of the Case

1. Company ‘K’ is a private limited company engaged in the business of organizing tours and other related travel services. In June 2001, ‘K’ entered into various agreements with company ‘T’ and its principal shareholders and directors, viz., ‘M’ and ‘A’. These agreements relate to the following:

(i) Brand agreement

 

Under this agreement, ‘K’ obtained an exclusive license to use ‘T’s trademark (the mark is pending registration and is in the name of ‘T’ in Mumbai under the Trade and Merchandise Marks Act, 1958) for a period of five and a half years with an exclusive option to acquire the trademark earliest at the expiry of three years, i.e., earliest on June 30, 2004, at a consideration contingent upon future earnings.

Under this agreement, ‘K’ obtained an exclusive license to use T’s domain name ‘www.net’ (‘domain name’) for a period of 15 months with an exclusive option to purchase the domain name at the closing date, i.e., September 30, 2002, at a pre-determined price.

 

(iii) Consultancy agreement

 

Under this agreement, ‘M’ has been appointed as a consultant for a period of three years, for a pre-determined compensation. In case the closing date for ‘K’ to exercise its option to acquire the trademark is extended to year four and/or year five, the consultancy agreement would also be extended for the similar period but no consideration would be payable for the extended period.

 

(iv) Non-compete agreement with ‘M’ and ‘A’:

 

Under this agreement, ‘A’ has agreed not to compete with ‘K’s business for a period of five years from July 1, 2001, and ‘M’ has agreed not to compete for a period of five years from the date of purchase of the trademark by ‘K’.

2. The querist has provided a synopsis of the brand agreement which states as follows:

(i) Under the brand agreement, ‘K’ has paid a non-refundable fee of Rs. 67 for the exclusive use of the trademark for a period of five and a half years. If ‘K’ exercises its right to acquire the trademark by June 30, 2004, (earliest date for exercising the option to acquire the trademark), the license period shall stand appropriately shortened. On ‘K’ exercising its right to acquire the trademark, ‘T’ will execute a deed of assignment in favour of ‘K’ transferring legal ownership rights of the trademark to ‘K’.

(ii) ‘T’ has represented that the use of trademark during the license period will result in ‘K’ earning certain profits in year one, two and three. Based on the profits earned, ‘K’ will make payments to ‘T’ in accordance with the formula set out in the brand agreement. Till such time ‘K’ does not exercise its right to acquire the trademark or declines to acquire the trademark, these payments are advance payments for both ‘K’ and ‘T’ and would be adjusted against consideration payable for the acquisition of the trademark,if the option to purchase the assets from ‘T’ is exercised by ‘K’.

(iii) If the estimated profits from the use of trademark during year one, two and three are not achieved, then the closing date for ‘K’ to exercise its option to acquire the trademark is extended to year four and/or year five. It is pertinent to note that no minimum guaranteed price has been agreed for purchase of the trademark.

(iv) In case ‘K’ chooses not to acquire the trademark, ‘T’ is obliged to return all amounts paid as advances towards acquisition of the trademark by ‘K’. In addition to the above, under the following circumstances also, ‘K’ would be entitled to a refund of advances made for the trademark:

(a) If the business from use of the trademark incurs a loss in any year till ‘K’ exercises its option to acquire;

(b) If ‘T’, ‘M’ or ‘A’ commit a breach of any provision of any of the above agreements; and

(c) ‘M’ suffers from any mental or physical incapacity within one year of the date of the agreement.

(v) Till the time the option to acquire trademark is exercised by ‘K’, ‘K’ has only the right to use the trademark and cannot be the legal owner or have ownership rights. The ownership rights continue to be vested with ‘T’ during the license period.

(vi) Pending the decision to acquire the trademark, ‘K’ has agreed to make advance payments towards acquisition of trademark at regular intervals as follows:

(‘x’ would represent the difference between the profit represented by ‘T’ and actual profit).

In addition to the above, separate considerations are being paid under website and domain name agreement, consultancy agreement, and non- compete agreement.

 

(vii) In addition to the above payments, ‘K’ shall also pay interest @10 per cent per annum from July 1, 2001, to the actual date of payments or up to June 30, 2004, whichever is earlier, only if it acquires the trademark.

3. According to the querist, there can be two methods of accounting and disclosure of the brand agreement in the books of ‘K’. The querist has described the two methods as Option A and Option B.

4. The querist has stated that the accounting treatment under Option A would be as follows:

(i) License Fees

To amortise the license fee under the brand agreement over the period of the agreement.

(ii) Advance payments towards acquisition of trademark

To account for and disclose as advances recoverable until such time ‘K’ exercises its option to acquire the trademark or declines to acquire it.

 

(iii) Trademark

 

To capitalise only after ‘K’ purchases them, i.e., from the date of purchase as per the agreement and thereafter amortise over their respective useful lives.

 

(iv) Disclosure in notes to accounts

 

(a) Under this option, no note would be included in the accounts with reference to Schedule VI (Note (g)) to the Companies Act, 1956, which mandates that any reference to benefits expected from the contracts to the extent not executed shall not be made in the balance sheet but shall be part of directors’ report.

           (b) There is no commitment on capital account as it is an option available to ‘K’.

(c) Under this option, the balance payments are not a contingent liability since the contracts entered into do not cast any liability on ‘K’. The liability arises only at the time when ‘K’ exercises its option to acquire the trademark.

5. As per the querist, the following is the rationale for following Option A:

(a) Obligation of ‘K’ to pay the advances arises when the use of trademark of ‘T’ during the license period results in ‘K’ earning profits, i.e., the obligation to pay advances is contingent in nature.

(b) ‘T’ is obliged to return advances paid by ‘K’ in the event that ‘K’ chooses not to acquire the trademark.

(c) ‘K’ has been legally advised that above agreements are exclusive and independent of each other and that its right to use the trademark is independent of its right to acquire the trademark.

(d) All legal titles are not transferred in favour of ‘K’ on July 1, 2001. The legal title would be transferred only after the option to acquire the same is exercised. The option cannot be exercised before June 30, 2004.

(e) The legal effect of the agreements is not to bring about a transfer of all the risks and rewards to ‘K’. The exploitation of the benefits of the trademark is by virtue of the brand agreement.

(f) The cost of acquisition cannot be ascertained reliably until the exercise of the option as the consideration will be dependent on the future profits earned.

6. The querist has stated that the accounting treatment under Option B would be as follows:

(i) Capitalisation of trademark on July 1, 2001

Capitalise the intangible assets (right to acquire trademark) on July 1, 2001 at Rs. 791 being the estimated consideration payable (including license fees of Rs. 67) by ‘K’ to ‘T’ on the trademark achieving the profits represented by ‘T’. Thus, the license fee paid as well as the liability towards future payments would all be capitalised.

(ii) Amortisation of intangible assets

Amortise intangible assets from date of use, i.e., July 1, 2001.

(iii) Disclosure in the notes to accounts

Disclosure of the fact that the consideration payable for the brand acquisition would vary based on profits generated by use of the trademark.

7. As per the querist, following is the rationale for adopting Option B:

(a) The agreement, if treated as a whole, despite its form, is in substance the purchase of the trademark.

(b) The risks and rewards from the business arising from use of the trademark, i.e., the turnover, related expenditure and profits/losses arising from the use of the trademark belong to ‘K’ during the period of the license agreement.

          (c) The business arising from the trademark would operate as a division of ‘K’ and the business activity of ‘T’ would cease.

           (d) The consideration is to be paid much before the option to purchase is exercised.

           (e) Interest on consideration which remains unpaid (not advances) is payable by ‘K’.

(f) The profit targets in the agreement represented by ‘T’ for the three years from July 1, 2001, are approximately three times the amounts payable by ‘K’ by way of license fee, consultancy fee and non-compete fee to ‘T’, ‘M’ and ‘A’.

(g) The consideration envisaged between the two parties, i.e., the knowledgeable buyer and the knowledgeable seller has been determined and included in the agreement. Variations dependent on future event will be incorporated based on future developments.

(h) There are no developments at this stage to suggest that the option for acquisition of brand is not likely to be exercised. The company  has paid Rs. 297 as on June 30, 2002, towards the above agreements.

(i) As far as ‘T’ is concerned, they have parted with their entire business. If the payments are viewed as being only an advance to be repayable by them in the event of non-acquisition of the trademark by ‘K’, the transaction may not make any economic sense from their angle.

B . Query

8. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) What is the appropriate accounting treatment for the trademark - whether Option A or Option B as on June 30, 2002, should be followed?

(b) What disclosures would be required in the notes to accounts in respect of brand agreement?

C. Points considered by the Committee

10. The Committee notes that the company in question, namely, 'K', has acquired from 'T', an exclusive license to use the trademark for a period of 5 and 1/2 years and for this purpose it has paid a non-refundable fee of Rs. 67. The company has also acquired an exclusive option to acquire the trademark earliest at the expiry of 3 years. For this purpose, 'K' has agreed to pay Rs.33 on the date of the agreement and Rs. 197 after one year of signing the agreement as unconditional payments and has also agreed to pay, at the end of 1st, 2ndand 3rd year, amounts based on the estimated profits earned in accordance with a formula set out in the agreement. In case 'K' exercises its right to acquire the trademark these payments are considered as advance payments to be adjusted against the consideration payable for the acquisition of the trademark. In case 'K' decides not to exercise its option to purchase the trademark, the advance payments so made are to be returned to 'K'. The Committee further notes that if the estimated profits from the use of the trademark during years 1, 2 and 3 are not achieved, then the closing date for 'K' to exercise its option to acquire the trademark is extended to year 4 or year 5.

12. The Committee notes the following definitions of the terms ‘intangible asset’ and ‘asset’ as per paragraph 6 of AS 26 and the explanation thereto as per paragraph 7 thereof:

(a) controlled by an enterprise as a result of past events; and

(b) from which future economic benefits are expected to flow to the enterprise."

"7. Enterprises frequently expend resources, or incur liabilities, on the acquisition, development, maintenance or enhancement of intangible resources such as scientific or technical knowledge, design and implementation of new processes or systems, licences, intellectual property, market knowledge and trademarks (including brand names and publishing titles). Common examples of items encompassed by these broad headings are computer software, patents, copyrights, motion picture films, customer lists, mortgage servicing rights, fishing licences, import quotas, franchises, customer or supplier relationships, customer loyalty, market share and marketing rights. Goodwill is another example of an item of intangible nature which either arises on acquisition or is internally generated."

13. The Committee is of the view that, keeping in view the facts of the case, the right to use the trademark for the business of the company is an intangible asset as it meets the definitions of the terms ‘asset’ and ‘intangible asset’ reproduced above. However, in order to consider whether the right to use the trademark should be recognised as an intangible asset, the recognition criteria prescribed in paragraph 20 of AS 26, as reproduced below, are to be considered:

"20. An intangible asset should be recognised if, and only if:

(a) it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and

          (b) the cost of the asset can be measured reliably."

14. The Committee is of the view that since it is probable that the future economic benefits that are attributable to the right to use the trademark will flow to the enterprise and that the costs incurred to use the trademark can be measured reliably (viz., Rs. 67 paid by the company), the right to use the trademark is an intangible asset to be valued at cost, namely, Rs. 67 and that the same should be amortised over its useful life of 5 ½ years. In case Company K decides to purchase the trademark at the end of the 3rd, 4th or 5th year, the useful life of the right to use the trademark will get shortened accordingly, and the written down value at the time of purchase, if any, should be charged to the profit and loss account.

15. With regard to the right of acquisition of the trademark at the end of the 3rd, 4thor 5th year, as the case may be, the Committee is of the view that while such a right may meet the requirements of the definitions of the terms ‘intangible asset’ and ‘asset’, it does not meet the recognition criteria specified in paragraph 20(b) of AS 26 that the cost of the asset can be measured reliably, since the payments made as advances would be based on profits to be earned in future, even though one may consider that the payments, in substance, amount to acquisition of the trademark as argued by the querist under Option B. Accordingly, the payments made as advances should be treated as advances until it is decided to purchase the trademark. The trademark should be recognised as an asset when the decision to purchase the same is taken. The trademark so recognised should be shown at cost arrived at in accordance with the requirements of AS 26.

"88. An asset is recognised in the balance sheet when it is probable that the future economic benefits associated with it will flow to the enterprise and the asset has a cost or value that can be measured reliably."

By the same token, since the right to purchase the trademark does not meet the recognition criteria prescribed in the ‘Framework’, as discussed in paragraph 15 above with reference to AS 26, the same cannot be recognised as an intangible asset.

18. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8 above:

(a) The company should follow Option A subject to the recognition of the right to use the trademark as an intangible asset at Rs. 67 which should be amortised over its useful life as discussed in paragraph 14 above.

(b) Disclosures required by AS 26, for example, under paragraph 90, should be made from the date the Standard becomes mandatory for the company. Prior to AS 26 becoming mandatory, disclosures required by AS 10 should be made.

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1 Opinion finalised by the Committee on 28.10.2003.