A. Facts of the Case
1. A company is a listed company. It is a leading supplier of
multilayer film for flexible packaging industry and other speciality
applications. Its brief history is as under:
• The company was incorporated as private limited
company on 7th May, 1981.
• It was converted into closely held public limited company
in June 1994.
• The company made its Initial Public Offer (IPO) in
November 1994.
2. The querist has stated that the company had created
revaluation reserve of Rs. 2.11 crore as on 31st March, 1994
based on revaluation of its certain assets. The part of the revaluation
reserve was subsequently utilised for issue of bonus shares in the
ratio of 3:1 as on 29th June, 1994. Subsequently, IPO was made
for 10 lakh shares of Rs.10/- each at a premium of Rs.30/- per
share. The present break-up of paid up capital is as under:
(Rs.in lakh)
(a) Shares issued for cash at par 50.00
(b) Bonus shares issued out of general reserve 50.00
(c) Bonus shares issued out of revaluation
reserve 100.00
(d) Public issue at a premium of Rs.30/-
per share 100.00
—————
300.00
—————
3. The querist has further stated that the then Department of
Company Affairs issued a Circular in September 1994 prohibiting
the issue of bonus shares out of revaluation reserve. The Institute
of Chartered Accountants of India (ICAI) published a Guidance
Note on Availability of Revaluation Reserve for Issue of Bonus
shares in November, 1994. A reference was made to the Expert
Advisory Committee of the Institute of Chartered Accountants of
India in February 1996 seeking the opinion on the following issues:
“(i) Whether the qualification in auditor’s report as per the
aforesaid Guidance Note should be “one time” or “life
time”.
(ii) Whether adequate disclosure by way of notes to the
accounts with regard to the amount of revaluation and its
subsequent utilisation as stipulated under Schedule VI
would be sufficient and that no further qualification in
auditor’s report is needed in the subsequent year’s annual
accounts.
(iii) If the Committee is of the view that the qualification
should continue for lifetime, what should be the illustrative
manner of the qualification in the subsequent year’s audit
report?” (Emphasis supplied by the querist.)
4. According to the querist, the Expert Advisory Committee, after
considering the provisions of Part I of Schedule VI to the Companies
Act, 1956 and the Circular of the Department of Company Affairs
(DCA) had, inter alia, given the following opinion:
“(i) and (ii) The qualification in auditor’s report should continue
in subsequent years also. Only disclosure by way of notes to
the accounts as regards the amount of revaluation reserve
and its utilisation for the purposes of bonus shares is not
sufficient.” (Emphasis supplied by the querist.)
It also suggested the manner of the qualification in the subsequent
year’s audit report. Following the above opinion of the Expert
Advisory Committee, auditors of the company have been regularly
qualifying the auditors’ report in the following manner:
“The company when it was unlisted had issued bonus shares
on 29th June, 1994 for Rs.10 million (10,00,000 equity shares
of Rs.10/- each) by capitalising part of its revaluation reserve.
Accordingly, the paid-up equity share capital of the company
stands increased by Rs.10 million and the revaluation reserve
stands reduced by that amount. The issue of bonus shares as
aforesaid is contrary to the circular issued by the Department
of Company Affairs issued in September, 1994 and the
recommendations of the Institute of Chartered Accountants of
India issued in November, 1994.”
5. The audit committee of the company is of the opinion that the
aforesaid qualification has no legal sanctity considering the fact
that the DCA circular as well as the Guidance Note came into
effect much after the event of capitalisation and the recent ruling
of Supreme Court of India has upheld that the Companies Act
specifically permits utilisation of reserve arising out of revaluation
of assets for the purpose of issue of fully-paid up bonus shares
and as long as the Articles of Association of the company permits
such capitalisation, it is a valid and legal transaction. Therefore,
the audit committee has requested the auditors to drop the
qualification prospectively by making a reference to the Expert
Advisory Committee for reconsideration of its earlier opinion dated
September 23, 1996.
6. The querist has stated that there is a strong case for
reconsideration of the opinion to the effect that the qualification in
auditor’s report in the year of issue of bonus shares out of
revaluation reserve is sufficient and in the subsequent years, the
same qualification should not be continued for the following reasons
(emphasis supplied by the querist):
(a) As per section 210 of the Companies Act, 1956, the
audited accounts should clearly disclose the results of
the working of a company for the year. The overall
consideration should be that the financial statements for
the year should reflect a true and fair view as per section
211 of the Act. (Emphasis supplied by the querist.)
(b) To reflect a ‘true and fair’ view, it is necessary for the
company to show separately, in the year of revaluation
and thereafter for a period of five years, the amount of
increase made in the fixed assets and the corresponding
credit in revaluation reserve account, as required in Part
I of Schedule VI to the Companies Act. If bonus shares
are issued out of such revaluation reserve, then, on the
‘Liabilities’ side under the head “Share Capital’, a note
should appear that, of the shares, so many shares are
allotted as fully paid bonus shares out of revaluation
reserve. Such note should continue to appear in the
balance sheet as long as share capital is reflected.
(Emphasis supplied by the querist.)
(c) The object for which a company revalues its fixed assets,
is to show in the balance sheet their replacement cost at
the date of the balance sheet.
(d) As per the Guidance Note on Treatment of Reserve
Created on Revaluation of Fixed Assets, issued by the
Institute of Chartered Accountants of India, depreciation
should be provided on the basis of revalued figure.
However, a company has an option to adjust the additional
depreciation relatable to revaluation against Revaluation
Reserve. This is clear from paragraph 9 of the Guidance
Note on Treatment of Reserve created on Revaluation
of Fixed Assets which states as follows:
“9. A question may arise, as to whether the
additional depreciation provision required in
consequence of revaluation can be adjusted against
‘Revaluation Reserve’. As stated earlier, depreciation
is required to be provided with reference to the total
value of the fixed assets as appearing in the account
after revaluation. However, for certain statutory
purposes e.g., dividends, managerial remuneration
etc., only depreciation relatable to the historical cost
of the fixed assets is to be provided out of the
current profits of the company. In the circumstance,
the additional depreciation relatable to revaluation
may be adjusted against ‘Revaluation Reserve’ by
transfer to Profit and Loss Account. In other words,
as per the requirements of Part II of Schedule VI to
the Companies Act, the company will have to provide
the depreciation on the total book value of the fixed
assets (including the increased amount as a result
of revaluation) in the Profit and Loss Account of the
relevant period, and thereafter the company can
transfer an amount equivalent to the additional
depreciation from the Revaluation Reserve. Such transfer from Revaluation
Reserve should be shown in the Profit and Loss Account separately and an
appropriate note by way of disclosure would be desirable. Such a
disclosure would appear to be in consonance with the requirement of Part
I of Schedule VI to the Companies Act, prescribing disclosure of
write-up in the value of fixed asset for the first five years after
revaluation. (Emphasis
supplied by the querist.)
(e) Furthermore, the contention that in subsequent years,
there would be excess charge to the profit and loss
account to the extent of additional depreciation on
revalued assets, due to capitalisation of revaluation
reserve by issue of bonus shares in the earlier year
would not survive, if one refers to paragraph 12 of the
Guidance Note on Treatment of Reserve Created on
Revaluation of Fixed Assets, which reads as under:
“12. The revaluation of fixed assets is normally done
in order to bring into books the replacement cost of
such assets. This is a healthy trend as it recognises
the importance of retaining sufficient funds through
additional depreciation in the business for
replacement of fixed assets. As such, it will be
prudent not to charge the additional depreciation
against revaluation reserve, though this may result
in reduction of distributable profits. This practice
would also give a more realistic appraisal of the
company’s operations in an inflationary situation.”
(f) The Hon’ble Supreme Court in the recent decision in the
case of Bhagwati Developers vs. Peerless General
Finance and Investment Co. and Others (2005) Comp
LJ 377 (SC) has held that there is no specific bar under
the Companies Act for issue of bonus shares out of
Revaluation Reserve. As for the DCA circular, the Court
said that the Department’s communiqué was advisory in
nature, without any mandatory effect.
(g) The Central Council of the ICAI at its recent meeting,
while appreciating and accepting the decision of the
Supreme Court, has decided to suggest to the Ministry
of Company Affairs that changes be made in the law to
ensure that companies are not allowed to issue bonus
shares out of revaluation reserves.
(h) The ICAI’s Guidance Note on Availability of Revaluation
Reserve for Issue of Bonus Shares is silent on the
applicability of the qualificatory report to years subsequent
to the year of capitalisation of revaluation reserve. In
contrast, the ‘Statement on Treatment of Interest on
Deferred Payments’ does require that a note in the
balance sheet of a company in subsequent years should
appear and the auditor should refer to such note in his
report to the members (emphasis supplied by the querist).
(i) An illustrative manner of the qualification as
recommended by the Institute also suggests that it is a
one time qualification and has no relevance in subsequent
years because issue of bonus shares refers to event which has happened in a particular period covered by
the audit report (emphasis supplied by the querist).
(j) Schedule VI, Part I, prescribing the form of balance sheet
while dealing with revaluation of fixed assets requires
that where the fixed assets are revalued and the sums
have been added by writing-up the assets, every balance
sheet subsequent to such writing up shall show the
increased figure with the date of increase in place of
original cost. Each balance sheet for the first five years
subsequent to the date of writing-up shall also show the
amount of increase made.
(k) The Guidance Note on Availability of Revaluation Reserve
for Issue of Bonus Shares is ambiguous on the issue
whether qualification is “one time” or “life time”. The bonus
shares once issued will form part of the share capital for
the life of the company and cannot be deleted unless
company goes for reduction of capital. Guidance Note
on Availability of Revaluation Reserve for Issue of Bonus
Shares in paragraph 5 states as under:
“5. Share capital represents the amount of
money or money’s worth received from the owners
and the capitalisation of earned profits or other gains
arising out of an arm’s length transaction. It has,
therefore, been a cardinal principle that only such
profits as are earned or the relevant capital receipts
(e.g., share premium), as are realised, can be
capitalised.”
This, according to the querist, would indirectly signify
that the qualification at the most can continue till such
time that the revaluation reserve is actually converted
into money or money’s worth upon the sale and realisation
of revalued assets. Alternatively, the amount equivalent
to revaluation reserve has to be provided and set aside
by way of additional depreciation from the realised profits
of the company to the extent of revalued amount.
(l) The management of the company contend that the then
prevailing provisions of the Companies Act, 1956 did not
prohibit or restrict the company from capitalising its
revaluation reserves by issue of bonus shares. The
capitalisation did not involve any release of the company’s
assets to its shareholders, and in fact it froze any
possibility of its distribution, except in the event of winding
up. Further, the Memorandum and Articles of Association
of the company also provided for and permitted the
capitalisation of revaluation reserves by issue of bonus
shares. The bonus shares were issued when the company
was a closely held company, to whom the guidelines for
issue of bonus shares by public company, as framed by
SEBI, did not apply at the relevant time.
B. Query
7. In view of the facts and circumstances of the case and the
legal position as confirmed by the recent Supreme Court decision,
the querist has requested the Expert Advisory Committee to
reconsider its earlier opinion and confirm that qualification is one
time qualification in the year of issue of bonus shares and that
adequate disclosure by way of notes to the accounts with regard
to amount of revaluation and its subsequent utilisation as stipulated
under Schedule VI would be sufficient compliance and that no
further qualification in auditors’ report is called for in the subsequent
years.
C. Points considered by the Committee
8. The Committee notes paragraphs 4, 5 and 6 of Guidance
Note on Availability of Revaluation Reserve for Issue of Bonus
Shares, which provide as follows:
“4. It may be noted that the excess of the revalued amount
over the net book value of fixed assets, which is credited to
revaluation reserve, is created as a result of a book adjustment
only. The revaluation reserve does not result from an arm’s
length transaction; it represents an expert’s perception of value.
The revaluation reserve thus does not represent a realised
gain.
5. Share capital represents the amount of money or money’s
worth received from the owners and the capitalisation of earned
profits or other gains arising out of an arm’s length transaction.
It has, therefore, been a cardinal principle that only such
profits as are earned or the relevant capital receipts (e.g.
share premium), as are realised, can be capitalised.
6. In view of the above, in the opinion of the Institute of
Chartered Accountants of India, bonus shares cannot be issued
by capitalisation of revaluation reserve. If any company
(including a private or a closely held public company) utilises
revaluation reserve for issue of bonus shares, the statutory
auditor of the company should qualify his audit report. An
illustrative manner of the qualification is given below:
“The company has issued bonus shares for Rs. ________
(__________equity shares of Rs. ___________ each)
by capitalising its revaluation reserve. Accordingly, the
Paid-up Equity Share Capital of the company stands
increased by Rs. ________ and the revaluation reserve
stands reduced by that amount. The issue of bonus
shares as aforesaid is contrary to the recommendations
of the Institute of Chartered Accountants of India.
Subject to the above __________”.”
9. The Committee notes that, subsequently, the Supreme Court
in the case of “Bhagwati Developers vs. Peerless General Finance
and Investment Company and Others” has allowed the utilisation
of the reserve arising from the revaluation of fixed assets for the
purpose of issuing fully paid-up bonus shares in the case of closely
held/ private and unlisted companies where the Articles of
Association of those companies specifically allow for such utilisation,
as the SEBI guidelines which prohibit such issue of bonus shares
out of revaluation reserve do not apply to issue of securities by
private/closely held and other unlisted companies. The Committee
also notes that the Supreme Court in the said case has also
recognised the fact that the Circular issued by the Department of
Company Affairs (now, Ministry of Corporate Affairs), regarding
‘Prohibition of Issue of Bonus Shares by Revaluation of Fixed
Assets’ does not have any mandatory effect and is merely advisory
in nature for private/closely held and unlisted companies. The
Committee further notes from the Facts of the Case that at the
time of issue of bonus shares out of revaluation reserve, the
company was a closely held company and the Memorandum and
Articles of Association of the company specifically allowed for such
issue of bonus shares. Accordingly, the Committee is of the view
that the above decision of the Supreme Court would be relevant in
the present case.
10. The Committee notes that the Council of the Institute has
issued an Announcement relating to “Disclosures in cases where
a Court/Tribunal makes an order sanctioning an accounting
treatment which is different from that prescribed by an Accounting
Standard”, which states as follows:
“Paragraph 4.2 of the ‘Preface to the Statements of Accounting
Standards’ (revised 2004) provides as under:
“4.2 The Accounting Standards by their very nature
cannot and do not override the local regulations which
govern the preparation and presentation of financial
statements in the country. However, the ICAI will
determine the extent of disclosure to be made in financial
statements and the auditor’s report thereon. Such
disclosure may be by way of appropriate notes explaining
the treatment of particular items. Such explanatory notes
will be only in the nature of clarification and therefore
need not be treated as adverse comments on the related
financial statements.”
In the case of Companies, Section 211(3B) of the Companies
Act, 1956, provides that “Where the profit and loss account
and the balance sheet of the company do not comply with the
accounting standards, such companies shall disclose in its
profit and loss account and balance sheet, the following,
namely:
(a) the deviation from the accounting standards;
(b) the reasons for such deviation; and
(c) the financial effect, if any, arising due to such
deviation.”
In view of the above, if an item in the financial statements of a
Company is treated differently pursuant to an Order made by
the Court/Tribunal, as compared to the treatment required by
an Accounting Standard, following disclosures should be made
in the financial statements of the year in which different
treatment has been given:
1. A description of the accounting treatment made
along with the reason that the same has been
adopted because of the Court/Tribunal Order.
2. Description of the difference between the accounting
treatment prescribed in the Accounting Standard
and that followed by the Company.
3. The financial impact, if any, arising due to such a
difference.
It is recommended that the above disclosures should be made
by enterprises other than companies also in similar situations.”
11. The Committee also notes that the Council has also issued
an announcement, ‘Clarification regarding Authority Attached to
Documents Issued by the Institute’, which clarifies the status of a
Guidance Note and an Accounting Standard as follows:
“5. ‘Guidance Notes’ are primarily designed to provide
guidance to members on matters which may arise in the course
of their professional work and on which they may desire
assistance in resolving issues which may pose difficulty.
Guidance Notes are recommendatory in nature. A member
should ordinarily follow recommendations in a guidance note
relating to an auditing matter except where he is satisfied that
in the circumstances of the case, it may not be necessary to
do so. Similarly, while discharging his attest function, a member
should examine whether the recommendations in a guidance
note relating to an accounting matter have been followed or
not. If the same have not been followed, the member should
consider whether keeping in view the circumstances of the
case, a disclosure in his report is necessary.” (Emphasis
supplied by the Committee.)
“7. The ‘Accounting Standards’ and ‘Statements on Standard
Auditing Practices’2 issued by the Accounting Standards Board
and the Auditing Practices Committee3, respectively, establish
standards which have to be complied with to ensure that
financial statements are prepared in accordance with generally
accepted accounting standards and that auditors carry out
their audits in accordance with the generally accepted auditing
practices. They become mandatory on the dates specified
either in the respective document or by notification issued by
the Council.4”
12. The Committee notes that Accounting Standards are
mandatory while Guidance Notes are recommendatory. Accordingly,
on a harmonious interpretation of the above announcements, the
Committee is of the view that the accounting treatment prescribed
by the Guidance Notes which are only recommendatory in nature
do not override the accounting treatment sanctioned in an order of
Court/Tribunal which, as per the Announcement reproduced in
paragraph 10 above, overrides the Accounting Standards that are
mandatory in nature.
13. On the basis of the above, the Committee is of the view that
the auditors of the company should not qualify the company’s
accounts on the matter of issuance of bonus shares out of
revaluation reserve after the issuance of Supreme Court decision
provided the company has made, in its financial statements, the
disclosures required as per the Announcement reproduced in
paragraph 10 above. Also, compliance should be made with regard
to Schedule VI requirements such as disclosure of the source
from which shares are issued, in each balance sheet.
D. Opinion
14. On the basis of the above, the Committee is of the opinion
that after the issuance of Supreme Court decision allowing issue
of bonus shares out of revaluation reserve, the auditor should not
qualify the accounts of the company in this regard, provided the
company has made, in its financial statements, the disclosures
required as per the Announcement reproduced in paragraph 10
above. Further, the requirements as to Schedule VI to the
Companies Act, 1956 have to be complied with as discussed in
paragraph 13 above.
1 Opinion finalised by the Committee on 9.8.2007.
2‘Statements on Standard Auditing Practices’ have since been renamed as
‘Auditing and Assurance Standards’ which have subsequently been reclassified
and renumbered as Standards on Quality Control, Auditing, Review, Other
Assurance and Related Services. The new format of classification and
renumbering of Standards is applicable from 1st April, 2008.
3The ‘Auditing Practices Committee’ has been renamed as ‘Auditing and
Assurance Standards Board’.
4Subsequent to the publication of this Clarification, the Council has made
various Accounting Standards mandatory.
|