Query No. 20

Subject:

Accounting for the difference between the issue price

and the market price of a share.¹

A. Facts of the Case

1. A company S Ltd., registered in India, renders software development services and provides embedded telecom solutions to the telecom companies outside India. It has been one of the preferred vendors of another company, viz., N, for the past one decade. N, either directly or through its subsidiary, was desirous of investing in the company in question. The intent of entering into an arrangement is to create additional value for the shareholders of S Ltd. and at the same time providing N an opportunity to share in the overall value created. Accordingly, negotiations between the company in question, i.e., S Ltd. and a wholly owned subsidiary of N, i.e., N-WOS began in December 2004 for N-WOS to invest in the company.

2. Accordingly, on April 6, 2005, the company S Ltd. entered into an agreement (Subscription Agreement) with N–WOS, whereby N-WOS subscribed to a certain number of equity shares of the company at a pre- determined price (exercise price). This price was agreed to with N-WOS during December 2004. This price was at a discount to the fair value of the company’s shares, as determined by the company’s auditors and category-I merchant bankers around the same time. Subsequently, on April 14, 2005, the company issued and allotted the equity shares to N- WOS. This difference between the fair value and the issue price to N- WOS has been referred to as ‘discount’ by the querist.

3. Some other investors were issued shares during the period April 14, 2005 to April 30, 2005. The price at which shares were issued to these other investors was more than the price at which shares were issued to N- WOS and also more than the fair value determined in December 2004.

4. On April 6, 2005, an amendment was made to the existing Services Agreement of the company S Ltd. with customer N to render software development and other services (‘ASA’) . Under the terms of this ASA, the customer N has guaranteed certain volume of business (‘guaranteed business’) to the company and its wholly owned subsidiary over a period of three years effective from January 1, 2005 (‘commitment period’). Under the terms of the said ASA, to the extent the customer is unable to honour the guaranteed business during such commitment period, the customer will be obligated to pay to the company, an additional amount as volume premium, to the extent of the shortfall, when compared to the guaranteed business at the end of the commitment period (‘Additional Payment’). The ‘Additional Payment’ is subject to the fact that N-WOS should have subscribed to the shares of S Ltd. during the commitment period. Such subscription to the shares has taken place on April 14, 2005.

5. According to the querist, there can be various alternatives with regard to accounting for the ‘discount’, as discussed hereinafter.

Historical Approach

6. Since, according to the querist, an enterprise is expected to prepare and present its financial statements based on the accrual basis of accounting, the effects of transactions and other events are recognised when they occur and are, accordingly, recorded and reported in the financial statements of the periods to which they relate. This is the essence of historical cost/value convention as per the querist. Under this approach, the amount to be credited to the ‘Securities Premium Account’ would be the excess of the actual issue price over the paid up value of the share.

7. In this regard, the querist has stated that currently there is no specific accounting standard/guidance note/requirement under Indian GAAPs, which addresses the accounting for equity instruments or equity-linked instruments such as rights to subscribe to equity shares, except when such instruments are issued to employees [such as employee stock options, stock purchase plans, etc]. The Guidance Note issued by the Institute of Chartered Accountants of India (ICAI) on ‘Accounting for Employee Share-based Payments’, which is effective from April 1, 2005, does not cover transactions of issuance of equity-linked instruments to non- employees/third parties.

8. According to the querist, this approach may have the following two variants:

(i) As and when the customer honours the guaranteed business during the commitment period, the benefits are received in terms of sales and accounted for as revenue in those years and, accordingly, get reflected in the profit and loss accounts of those years. If, because of any shortfall in the guaranteed business, the company is entitled to receive “premium”, that too being an item of revenue, would be credited to the profit and loss account of that year.

(ii) This would be the same as variant at (i) above, but the volume premium, instead of being credited to the profit and loss account, may be credited to the ‘Securities Premium Account’ in that year.

Notional Approach

9. The ‘discount’ (as may be determined on the basis of an independently appraised fair valuation of shares at the time of its issue), may be dealt with as discussed below:

(i) Variant A: One alternative could be that, at the time of the issue of shares, the ‘discount’ is debited to an appropriate account, say, Assured Volume Business Amortisation Account (which is to be amortised over the commitment period), the corresponding amount being credited to the Securities Premium Account. The Assured Volume Business Amortisation Account is proposed to be reflected as a debit under ‘Reserves and Surplus’ until the same is fully amortised (similar to the accounting treatment followed in case of Employees Stock Option Plan).

(ii) Variant B: Alternatively, the ‘discount’ is debited to an appropriate account, say, ‘Assured Volume Business Suspense Account’, but instead of making the corresponding credit entry to the Securities Premium Account, it is credited to an account called ‘Securities Premium Suspense Account’, and on the expiry of the commitment period (or on the entitlement of the premium), the former is transferred to the debit of the profit and loss account and the latter to the credit of the profit and loss account.

(iii) Variant C: This would be the same as Variant A but the corresponding amount would be credited to Securities Premium Suspense Account instead of Securities Premium Account. This treatment is proposed since the amount, i.e., the ‘discount’ would not have been received in cash.

10. The querist has made certain observations with regard to the alternative approaches discussed above, as follows:

(i) The accounting treatment suggested in paragraph 8(i) is based on the conventionally accepted accounting principle of historical cost. According to the querist, various Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI) are based on historical approach. One of the fundamental accounting assumptions underlying the preparation and presentation of the financial statements, as specified in Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, is ‘accrual’, according to which, the revenues and costs are recognised as they are earned or incurred [refer paragraph 10(c) of AS 1].

Accounting Standard (AS) 2, ‘Valuation of Inventories’, refers to the cost of inventories as ‘incurred’, i.e., historical cost [refer paragraph 6 of AS 2].
 

Similarly, Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, also basically requires reckoning with actual historical cost unless there is a restatement to reflect the effects of changing prices [refer paragraphs 2, 6.3, 9 and 19 of AS 10].

Likewise, Accounting Standard (AS) 13, ‘Accounting for Investments’, while dealing with the cost of an investment, uses the historical cost of an investment [refer paragraph 9 of AS 13].

Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India, requires revenue to be recognised when the event related to the revenue is accomplished, for example, on the sale of goods, the revenue is recognised, when the seller of goods has transferred to the buyer, the property in the goods for a price or all significant risks and rewards of the ownership have been transferred. Thus, this Standard also uses historical approach.

According to the querist, if one accounts for the ‘discount’, it may mean accounting for an expense that is not even incurred, i.e., which is notional or unreal. This might suggest that the ‘discount’ should not be recorded, when it is actually not incurred and it may appear to be more appropriate to adopt the approach mentioned in paragraph 8(i), which is in compliance with the generally accepted accounting principles.

The querist has also pointed out that several public companies issue/allot shares on ‘right’ or ‘preferential’ basis at a price lower than the market value and, according to the querist, none of these companies account for such excess of the market value over the issue price as securities premium, instead of the actual premium amount.

(ii) What is mentioned for paragraph 8(i) above, would also apply to the alternative given under paragraph 8(ii), except that crediting the volume premium for the shortfall to the Securities Premium Account would not be correct in as much as the volume premium arises out of the ordinary activities of the company, i.e., from the sale of goods. In fact, the volume premium is also received due to specified conditions and accordingly, it should be recognised in the statement of profit
and loss of the company and not to the Securities Premium Account. In fact, AS 9 also does not seem to suggest that any item of revenue may be recognised otherwise than in the profit and loss account, i.e., in the balance sheet.

(iii) With regard to Variants A and C of the ‘Notional Approach’ discussed in paragraph 9 above, the amount debited to the Volume Business Amortisation Account is a notional or imaginary amount and nothing is recoverable on this account and accordingly, in terms of Accounting Standard (AS) 26, ‘Intangible Assets’, issued by the Institute of Chartered Accountants of India, this item would not be covered by the definition of an ‘intangible asset’, in the view of the querist, and the entire amount may have to be charged to the profit and loss account (and not amortised over the commitment period). [Refer paragraph 55 of AS 26 and also Guidance Note on Audit of Miscellaneous Expenditure (2003) of ICAI].

(iv) With regard to Variant B of the Notional Approach as discussed in paragraph 9 above, it will have a neutralising effect in the profit and loss account.

11. The querist has stated that both these options (the account being the Securities Premium Account or Securities Premium Suspense Account) may have implications under section 78 of the Companies Act, 1956, which permits a very restricted use of the amounts credited to the Securities Premium Account.

12. The querist has drawn the attention of the Committee to the Guidance Note on Terms Used in Financial Statements, issued by the Institute of Chartered Accountants of India, which defines ‘Share Premium’ as ‘the excess of the issue price of shares over their face value’, so that ‘discount’ cannot partake the character of the securities premium so defined.

B. Query

13. Having regard to the foregoing, the querist has sought the opinion of the Expert Advisory Committee on the correct accounting treatment in respect of:

(i) the amount to be credited to the Securities Premium Account, when the shares are issued;

(ii) the revenue (including premium if the guaranteed volumes are not achieved) related to the transactions of the company in terms of the contract with the allottee of the shares;

(iii) if the credit to the Securities Premium Account is the full excess of the independently appraised share value over its paid up value, accounting treatment of the ‘discount’ that would consequently emerge and especially whether it can be amortised over the term of the contract. Also, whether such discount should be recorded as an expense or be reduced from the sales/revenues similar to ‘trade discount’;

(iv) any other more appropriate accounting treatment instead of the treatment set out under each of the two options (Historical Approach and Notional Approach) together with their respective variants, and the disclosures to be made under the suggested accounting treatment.

C. Points considered by the Committee

14. The Committee notes from the Facts of the Case that the company in question, under a composite deal, has issued shares to N-WOS, at less than the fair value of the shares in return of the guaranteed business from N, which is the holding company of N-WOS. The Committee further notes that in case, N is not in a position to provide the guaranteed business over the specified commitment period, it would make payment to the company, termed as ‘additional payment’, for the difference between the actual business provided and the guaranteed business. The Committee is, therefore, of the view that the company in question has obtained a valuable right in the form of guaranteed future business from N, in consideration of the issue of shares at less than their fair value. In the view of the Committee, this right is an asset and its value can be measured as the difference between the fair value of the shares and the price at which the shares are issued to N-WOS. In other words, in the view of the Committee, the shares are not issued at a ‘discount’, as stated by the querist, because shares are issued at discount when no commensurate return is received; in this case, however, there is a return in the form of the right of guaranteed business over the commitment period from N. Accordingly, the Committee is of the view that the company has obtained an intangible asset as it fulfills the definitions of ‘Intangible Asset’ and ‘Asset’ as per Accounting Standard (AS) 26, ‘Intangible Assets’, issued by the Institute of Chartered Accountants of India, and it meets the recognition criteria specified in paragraph 20 thereof, which are reproduced below:

“An intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.”

“An asset is a resource:

(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.”

 

“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.”

15. The Committee is of the view that the right to the guaranteed business meets the definition of ‘asset’ as defined above, as it represents a resource controlled by the enterprise as a result of past event, viz., the issue of shares to N-WOS, from which future economic benefits in the form of the guaranteed business from N are expected to flow to the company in question. The said right meets the definition of ‘Intangible Asset’ as defined above as it is an identifiable non-monetary asset, without physical substance, held for use for obtaining the guaranteed business in future.

16. The Committee is further of the view that the recognition criteria specified in paragraph 20 of AS 26, as reproduced above, are met because it is probable that the future economic benefits that are attributable to the right will flow to the enterprise either in the form of the guaranteed business from N, or in the event of not obtaining the guaranteed business, in the form of the additional payment to be made by N, to the extent of the shortfall. Further, the cost of the asset can be measured reliably as the difference between the fair value of shares and the price obtained from N-WOS.

17. The Committee is of the view that the difference between the face value of the shares and the fair value of the shares issued to N-WOS should be considered as share premium. The Committee is of the view that the ‘issue price’ is the fair value of the shares issued to N-WOS which is received in the form of cash and also in kind, viz., the intangible asset, i.e., the right to guaranteed business. That being the ‘issue price’, the definition of ‘share premium’ as per the Guidance Note on ‘Terms Used in Financial Statements’, referred to by the querist in paragraph 12 above, is met.

18. The Committee is of the view that recognition of the intangible asset and a simultaneous recognition of the share premium are in accordance with the accrual basis of accounting since the asset is recognised as per AS 26 and the share premium is recognised as discussed above.

19. The intangible asset, namely, the right to guaranteed business, should be amortised in accordance with the requirements of paragraphs 63 and 72 of AS 26 as reproduced below:

“63. The depreciable amount of an intangible asset should be allocated on a systematic basis over the best estimate of its useful life. There is a rebuttable presumption that the useful life of an intangible asset will not exceed ten years from the date when the asset is available for use. Amortisation should commence when the asset is available for use.”

“72. The amortisation method used should reflect the pattern in which the asset’s economic benefits are consumed by the enterprise. If that pattern cannot be determined reliabily, the straight-line method should be used. The amortisation charge for each period should be recognised as an expense unless another Accounting Standard permits or requires it to be included in the carrying amount of another asset.”

20. On the basis of the above, the Committee is of the view that the intangible asset, viz., the right to the guaranteed business, should be amortised over a period of 3 years, being the useful life of the right, i.e., the commitment period over which the guaranteed business is to be provided by N, and failing that it will make the additional payment for the shortfall. Pursuant to the requirements of paragraph 72 of AS 26, the amortisation method should reflect the pattern in which the asset’s economic benefits are consumed by the enterprise, for example, the pattern can be determined on the basis of the business obtained by the company during the commitment period.

21. The Committee is of the view that in case N is not able to fulfill the commitment towards the guaranteed business during the commitment period, the unamortised balance of the intangible asset should be charged to the profit and loss account and the amount received as additional payment, being the compensation for inability to meet the commitment, should be separately credited as ‘other income’ in the profit and loss account. The Committee is of the view that the amount so received cannot be treated as ‘revenue’ within the meaning of Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India, since the amount of compensation is not realised on the ‘sale of goods, from the rendering of services or from the use by others of enterprise resources yielding interest, royalties and dividends’ (paragraph 4.1 of AS 9) but is on account of compensation received for not meeting the commitment for the guaranteed business.

D. Opinion

22. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 13 above:

(i) The amount to be credited to the share premium account is the difference between the fair value of the shares and the face value of the shares allotted to N-WOS.

(ii) As discussed in paragraph 21 above, it is not correct to term the amount received as ‘revenue’ if the guaranteed volume of business is not received. This should be reflected as ‘other income’ in the profit and loss account.

(iii) The credit to the share premium account does not result in a discount as discussed above. On the contrary, it gives rise to an intangible asset to be amortised as discussed in paragraph 20 above.

(iv) None of the approaches described by the querist is correct since an intangible asset should be recognised. The Committee is further of the opinion that the disclosures prescribed in AS 26 should be made.

¹ Opinion finalised by the Committee on 17.8.2005