Query No. 24

Subject:

Accounting for conversion of membership rights of erstwhile BSE

(AOP) into trading rights of BSEL and shares. ¹

A. Facts of the Case

1. The querist has stated that the BSE had till recently been functioning as an Association of Persons (AOP). Brokers/members of the erstwhile BSE (a recognised stock exchange registered as an association of persons) had been holding membership card which gave them (a) the ownership rights in the AOP and (b) exclusive rights to carry on business as a stock broker.

2. In the past, one could trade in this membership card with the value being in the range of Rs. 7 million to Rs. 40 million. According to the querist, before the introduction of Accounting Standard (AS) 26, ‘Intangible Assets’, issued by the Institute of Chartered Accountants of India, as no specific guidance was available, this membership card was classified as a fixed asset or as an investment. In case it was classified as an investment, it was evaluated for diminution other than temporary. Similarly, if it was classified as a fixed asset, the same might or might not have been depreciated as it was considered to have perpetual life.

3. With the introduction of AS 26, this membership right was considered to fall under the purview of the Standard. Accordingly, the same was classified as part of intangible assets (disclosed as fixed asset). The membership right was considered to have perpetual existence and there was no defined useful life. As there is a presumption in AS 26 that the useful life of an intangible asset is 10 years (unless substantiated otherwise), the stockbrokers were amortising this intangible asset over a period of 10 years. This treatment had been confirmed by an earlier opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India (published in the Compendium of Opinions – Volume XXIV, Query No. 2).

4. The BSE (Corporatisation and Demutualisation) Scheme 2005 seeks to convert BSE from association of persons to a corporate body, ‘Bombay Stock Exchange Limited’ (BSEL), with effect from the due date. This scheme, subject to certain conditions and modifications, had been approved by the Securities and Exchange Board of India (SEBI) on 29th May, 2005. The scheme has been effective from 19th August, 2005 (due date). The objective of the scheme is to separate the ownership of BSE from the right to trade. Thus, as per the scheme, owners would no longer necessarily be traders and vice versa.

5. As per this scheme, all the existing members of the AOP shall be entitled to 10,000 fully paid-up equity shares of face value of Re.1/- each for cash at par of the corporate entity, BSEL. The scheme also mentions that BSEL may list its securities at any time on a recognised stock exchange. The net book value of each share, according to the querist, is over Rs. 1,000. In the view of the querist, the intention seems to be that the owners of the AOP should be compensated for the loss in the value of exclusive trading right and proportionate ownership of AOP up to the date of the scheme.

6. An existing member of AOP who is registered with SEBI has the trading rights with BSEL with effect from the due date. After the due date, a person (other than the existing member of AOP) desirous of carrying stock brokerage business of any segment of Bombay Stock Exchange Limited can also be admitted if he complies with the requirements and brings in specified fees and deposits as specified in the rules, bye-laws and regulations of BSEL. SEBI has allowed a provision for additional privileges to the existing members with its prior approval. The querist has informed that currently no such privileges have yet been given.

7. With regard to the transfer/surrender of the BSEL trading rights given to the existing members of AOP, the scheme does not specify as to whether any money would be received by the erstwhile AOP member on his surrendering the trading right. For trading members having deposit-based membership rights, the deposit is refundable. The Scheme also does not specify as to whether this trading right given to the erstwhile AOP members can be transferred to any other person. However, a deposit-based trading membership right of BSEL is available to any person who satisfies the requisite conditions.

8. The scheme clearly mentions that:

-Trading right holder may or may not be a shareholder.

-A shareholder may or may not be a trading right holder. As per the querist, all the assets and liabilities of the erstwhile BSE would be transferred to BSEL.

9. The querist has summarised the benefits accruing to the members of the erstwhile BSE as follows:

-They would continue to have the trading rights on the BSEL similar to the new deposit-based membership rights without making the deposit.

-They have received 10,000 shares for a total consideration of Rs. 10,000, i.e., at Re. 1/- per share. However, the fair value of BSEL’s shares is expected to be significantly higher than the value at which the corresponding shares have been issued. This is based on the expected book value of the net assets and the earnings per share of the erstwhile BSE to be transferred to BSEL.

10. The querist has stated that in case an old member intends to surrender the trading right, he may not get any value for the right as there may not be any willing buyers for this right when there is a refundable deposit-based right available. However, by virtue of being a shareholder of BSEL and the fact that the book value is expected to be significantly higher than the cost of acquisition of such shares, the old members are expected to benefit from the shares allotted to them.

11. The querist has given two views for the above mentioned transactions and also the possible accounting treatments thereof which are as follows:

         (i) View 1

                As far as the trading right is concerned, there is no exchange of assets and this should be continued to be carried forward as an intangible asset. The shares of the BSEL received under the corporatisation scheme of the BSE should be shown as an investment at acquisition cost, i.e., Rs. 10,000. This view is based on the premise that as a result of corporatisation and demutualisation, the trading rights of a member of the erstwhile BSE (AOP) remain unaffected, while he additionally gets 10,000 shares at a price of Re. 1 each.

          Proposed accounting treatment:

              The WDV of the membership card of AOP in the books at the effective date should continue to be carried forward as an intangible asset and written off over its balance useful life out of the original ten years (and not 10 years counted afresh). The 10,000 shares of BSE should be shown as an investment at Rs. 10,000, i.e., acquisition cost.

         (ii) View 2

A cardholder of the erstwhile BSE (AOP) gets shares in BSEL which is an entity totally separate and distinct from BSE (AOP). He also gets trading rights which are otherwise available against deposit. Thus, from a legal angle, the transaction involves giving up the rights of one legal entity [BSE (AOP)] and acquiring trading rights and shares of another legal entity (BSEL). The membership card of BSE and shares of the new company are two distinct and separate legal instruments and holding thereof gives to the holder separate and distinctive legal rights. From the angle of economic substance also, the membership card of the erstwhile AOP now results in two separate assets, viz., the trading right and the equity shares. The new trading right and issue of shares are part of a single package given to the existing members of the BSE (AOP) in exchange of their old trading right. Acknowledging the fact that the new trading right received by the existing member may have a lower fair value (because there is no market for this trading right and the fair value will primarily reflect the cost savings, i.e., the present value of the cost of deposit), it appears that the loss in the value of the old right due to corporatisation of BSE has been compensated through issue of equity shares at a nominal price. Thus, the fair value of the old trading right (before corporatisation) will now be available to the member as gain through the fair value of the equity shares so received. If this were not the business rationale, the equity shares would not have been issued at a nominal price. The present situation is one where the membership card of the AOP was an intangible asset. Against this intangible asset, two assets have been acquired. The first is the right of trading which is no longer an exclusive right. The second is an investment in the new company. As far as the shares of BSEL are concerned, their allotment to members of AOP recognises the fact that earnings of the AOP till date belong to the members of the AOP. It is also evident that the arrangement is such that the existing members are compensated through the shares for the loss of their exclusivity of trading rights. It is clear that allotment of shares at Re. 1 each is not representative of the economic reality. Thus, it would not be proper to record these shares at Re. 1 each.

          Proposed accounting treatment:

          In this case, one needs to apply paragraph 29 of Accounting Standard (AS) 13 ‘Accounting for Investments’, paragraphs 11.1 and 22 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, paragraph 34 of AS 26 and the concept of prudence as per Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, issued by the Institute of Chartered Accountants of India. The card of BSE (AOP) entitles the holder to two distinct rights described above. Therefore, the existing carrying amount of the card plus Rs. 10,000 needs to be allocated to the two rights on the basis of their fair values at the date of their acquisition (emphasis supplied by the querist).

The fair value of 10,000 shares of BSEL can be determined on the basis of any one of the several widely used share valuation models, e.g., on the basis of book value per share, or earnings per share. In valuing the shares, one would, of course, need to also consider whether the earnings of BSEL would be distributable to members or not (it seems that at least the assets acquired from BSE (AOP) are not distributable; the position regarding distributability of earnings of newly formed BSEL is not clear).

The fair value of new trading right should reflect the differential advantage that the BSE (AOP) holder has over a new trading member, e.g., the erstwhile cardholder of BSE (AOP) does not have to pay the required deposit. This value would be ascribable to the present value of the cost of deposit, i.e., the net interest payable plus other costs of the funds. In case the aggregate fair value of shares and new trading right exceeds the carrying amount of the card, excess should not be recognised (effectively not recording any gain). If, on the other hand, the carrying amount of the card exceeds the above- mentioned aggregate, the excess would need an immediate write-off. As far as the value of the shares is concerned, their carrying amount and disclosure would depend upon the intent whether they are being held as long term investments or current investments.

B. Query

12. The querist has sought the opinion of the Expert Advisory Committee as to which of the two views stated above should be followed.

C. Points considered by the Committee

13. The Committee notes from the Facts of the Case that under the BSE corporatisation and Demutualisation Scheme 2005, a member of the erstwhile BSE (AOP) receives two assets, namely, 10,000 shares in the BSEL for a nominal value of Rs. 10,000 and a trading right in the BSEL. Thus, a member of the AOP gets an investment in the form of shares in BSEL and an intangible asset in the form of trading rights in BSEL in exchange of his existing intangible asset, i.e., membership card.

14. As far as the value at which the shares in the BSEL should be recorded, is concerned, the Committee notes paragraph 11 of AS 13, which states as follows:

 “11. If an investment is acquired in exchange, or part exchange, for another asset, the acquisition cost of the investment is determined by reference to the fair value of the asset given up. It may be appropriate to consider the fair value of the investment acquired if it is more clearly evident.”

15. The Committee further notes paragraph 34 of AS 26 and paragraphs 11.1 and 22 of AS 10 which state as follows:

           AS 26

 “34. An intangible asset may be acquired in exchange or part exchange for another asset. In such a case, the cost of the asset acquired is determined in accordance with the principles laid down in this regard in AS 10, Accounting for Fixed Assets.”

            AS 10

   “11.1 When a fixed asset is acquired in exchange for another asset, its cost is usually determined by reference to the fair market value of the consideration given. It may be appropriate to consider also the fair market value of the asset acquired if this is more clearly evident. An alternative accounting treatment that is sometimes used for an exchange of assets, particularly when the assets exchanged are similar, is to record the asset acquired at the net book value of the asset given up; in each case an adjustment is made for any balancing receipt or payment of cash or other consideration.”

 “22. When a fixed asset is acquired in exchange or in part exchange for another asset, the cost of the asset acquired should be recorded either at fair market value or at the net book value of the asset given up, adjusted for any balancing payment or receipt of cash or other consideration. For these purposes fair market value may be determined by reference either to the asset given up or to the asset acquired, whichever is more clearly evident. Fixed asset acquired in exchange for shares or other securities in the enterprise should be recorded at its fair market value, or the fair market value of the securities issued, whichever is more clearly evident.”

16. On the basis of the above, the Committee is of the view that, in the present case, the assets exchanged are dissimilar – the asset given up is a membership card which is an intangible asset and the assets acquired are an investment and an intangible asset, which entitle the holder separate and distinct legal rights. In view of this, the alternative accounting treatment provided in paragraph 11.1 of AS 10 would not be appropriate. Accordingly, the fair value approach prescribed in that paragraph should be followed for determining the value at which the assets acquired should be recorded, i.e., fair value of the asset given up or fair value of the asset acquired, whichever is more clearly evident. Also, in view of the requirements of paragraph 11 of AS 13, the Committee is of the view that it would be appropriate to adopt fair value approach for valuing investment in the shares of BSEL. Further, since the querist has stated in paragraph 10 above that in the present case there may not be potential buyers for the existing card (the asset given up), in the view of the Committee, the fair value of the asset given up is not clearly evident. Accordingly, as per the above reproduced provisions of AS 10 and AS 13, investment in the shares of BSEL and trading rights in the BSEL should be recorded at their respective fair values. The resultant gain or loss should be transferred to the profit and loss account. This view is different from the View 2 suggested by the querist in paragraph 11 above as in this approach the shares and the new trading rights acquired have to be recorded at their respective values rather than the carrying amount of the existing card being allocated to the two assets on the basis of their fair values.

17. The Committee is of the view that the accounting treatment suggested by the querist as View 1 of paragraph 11 above, which is based on the historical approach should not be followed in the present case as the Accounting Standards do not envisage historical cost based accounting treatment in case of transactions involving exchange of assets.

18. Regarding the amortisation of trading right, the Committee is of the view that, as discussed in paragraph 16 above, the trading right in the BSEL is an altogether different asset from the erstwhile trading and membership right in the BSE (AOP). Accordingly, it should be amortised afresh over the best estimate of its useful life subject to the rebuttable presumption of 10 years, 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 connot be determined reliably, 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.”

D. Opinion

19. On the basis of the above, the Committee is of the opinion that the querist should not follow either of the views suggested in paragraph 11 above; rather, the accounting treatment suggested in paragraphs 16 and 18 above should be followed.