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Query No. 39
Subject: Accounting treatment of contribution to Settlement Guarantee Fund by an Exchange.
A. Facts of the Case
1. A public limited company, incorporated on April 23, 2003 under the Companies Act, 1956, is a professionally managed on-line multi commodity exchange (hereinafter referred to as the ‘company’ or the ‘Exchange’). It is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently in short supply in the commodity markets. The institutional promoters and shareholders of the company are prominent players in their respective fields and bring with them institutional building experience, trust, nation-wide reach, technology and risk management skills.
2. The company is regulated by the Forward Markets Commission (FMC), which is a regulatory authority overseen by the Ministry of Finance, Government of India. It is a statutory body set up in the year 1953 under the Forward Contracts (Regulation) Act, 1952.
3. The querist has stated that an exchange has an obligation for guarantee of settlement and therefore, there is a requirement to have a Settlement Guarantee Fund (SGF) which will be:
(i) a potent line of defense and fallback guarantee mechanism in case the multiple levels of safety are found inadequate to cover the settlement obligations.
(ii) a pool of funds which can be dipped into to make good the price risk on the amount under obligation of the defaulting member.
The Forward Markets Commission (FMC) has issued uniform guidelines to all national commodity exchanges, with respect to sources of funds for SGF and contribution by the exchanges to SGF, vide its letter No. 2/2/2008-MKT-II dated August 23, 2013 (hereinafter referred to as SGF Guidelines) (copy of which has been supplied by the querist for the perusal of the Committee).
4. The extracts of the Guidelines are as under:
(i) The components of SGF shall be:
(a) The initial contribution to SGF by the Exchange will be equivalent to 5% of the sum total of the gross revenues of the Exchange for the preceding financial years starting from financial year 2007-08 or from the date when the Exchange was set-up, till financial year 2012-13, subject to a minimum of Rs. 10 crore.
(b) Base Minimum Capital (BMC) of members (stipulated by the FMC as per letter No. 6/12/2012-MKT-I dated March 8, 2013).
(c) Interest accrued on Base Minimum Capital.
(d) Refundable deposits made by the members (other than margins) for trade, by whatever name called (i.e., the Base Capital collected by the Exchange).
(e) All settlement related penalties charged by Exchange from members with effect from September 1, 2013.
(f) The annual contribution by the Exchange will be 5% of its gross revenue of the previous year with effect from April 1, 2014.
(g) Interest amount and any other income accrued on investments of fund of SGF shall also be credited to SGF.
(ii) The margin collected by the Exchange from the members shall not be part of SGF.
(iii) The Exchange shall constitute a Committee for management of SGF, whose composition will be as under:
- An independent director appointed by FMC
- An independent director appointed with approval of FMC
- A member of the Exchange appointed in consultation with the members or association of members
- MD/CEO of the Exchange shall be the ex-officio member secretary to the Committee
The FMC, vide clause 2 of the above stated guidelines has specified that “the status of SGF funds should be shown separately in the head of account of the Exchange”. (Emphasis supplied by the querist.)
5. Subsequently, vide letter No. 2/2/2008-MKT-II dated 14th March, 2014 (copy of which has been supplied by the querist for the perusal of the Committee), the FMC has partially modified its earlier Guidelines dated 23rd August, 2013, as under:
(a) The Settlement Guarantee Fund shall not include the refundable deposits made by members for trade. However, the Base Minimum Capital (BMC) of members and interest income on investment of BMC will continue to be part of SGF.
(b) The Exchange shall on quarterly basis, make the risk assessment on SGF and shall make fresh contribution to SGF to meet the shortfall, if any, out of the revenue earned by them. The maximum contribution by an Exchange in the SGF in a year shall be up to 5% of the gross revenue (net of income tax to be paid by the Exchange). In cases where exchanges have sufficient funds available in the SGF to meet the contingent risk, then there is no need for exchanges to make any further contribution.
(c) The income accruing on the funds belonging to SGF shall be credited to SGF by the Exchange, net of income tax paid on such income.
(d) All settlement related penalties charged by the Exchange from members will continue to be part of SGF
6. As at March 31, 2014, the SGF corpus is presented in the financial statements as under:
(i) Refundable deposits from the members - Current/Non-current liability
(ii) Initial contribution by the Exchange - Reserves (Transferred from retained earnings)
As per the querist, there was no requirement for the annual contribution by the Exchange as at March 31, 2014 as per stress test stipulated in the Guidelines dated March 14, 2014. However, as per stress test done on June 30, 2014, the Exchange was required to make annual contribution of 5% of revenues of the previous year (i.e., revenue of financial year 2013-14).
Annual contribution by the Exchange to SGF – Whether liability or reserve?
7. The annual contribution to SGF is calculated as a percentage of revenues (and not of profits), i.e., the same will have to be made even in the absence of profits. Based on this, any contribution by the Exchange will be treated as a charge to profit and not appropriation. Therefore, one may consider SGF as a liability. However, going by the principle of ‘substance over form’, the objects and purpose of SGF indicate that the Exchange contribution to SGF is in nature of reserve due to following reasons:
(i) The obligation to guarantee settlement is with the Exchange and the Settlement Guarantee Fund is just an amount earmarked by the Exchange to meet this obligation, if and only if, the multiple layers of risk mitigation measures are found inadequate to cover settlement obligations. Therefore, SGF is a reserve created to meet any future unknown liability which is not crystallised or certain. Hence, any contribution by the Exchange to SGF should be treated as an appropriation and not as a charge to profits.
(ii) The amount contributed by the Exchange to SGF will remain with the Exchange as SGF is not with a separate entity.
(iii) As per clause (b) of the revised Guidelines dated March 14, 2014, the amount to be transferred to SGF is net of income tax to be paid by the Exchange. This reiterates that the contribution is an appropriation from retained earnings.
8. Views of the company
As stated above, the obligation to guarantee settlement is with the Exchange and the Settlement Guarantee Fund is an amount earmarked by the Exchange to meet this obligation, if and only if, the multiple layers of risk mitigation measures are found inadequate to cover settlement obligations. Therefore, in the view of the querist, SGF is a reserve and any contribution by the Exchange to SGF should be treated as an appropriation and not as a charge to profits.
B. Query
9. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the treatment of annual contribution to SGF by the Exchange and other contributions, as stated below:
(i) Annual contribution by the Exchange:
As per the revised Guidelines of FMC dated March 14, 2014, “The exchange shall on quarterly basis, make the risk assessment on Settlement Guarantee Fund (SGF) and shall make fresh contribution to the Settlement Guarantee Fund to meet the shortfall, if any, out of the revenue earned by them. The maximum contribution by an exchange in the Settlement Guarantee Fund in a year shall be up to 5% of the gross revenue (net of Income Tax to be paid by the exchange). In cases where exchanges have sufficient funds available in the Settlement Guarantee Fund to meet the contingent risk, then there is no need for exchanges to make any further contribution”.
Based on this, whether the annual contribution made by the Exchange to SGF should be charged to the statement of profit and loss or appropriated from profit after tax. Also, whether the same should be classified as a reserve or a liability in the balance sheet.
(ii) Income accruing on SGF:
As per revised Guidelines dated March 14, 2014, “The income accruing on the funds belonging to SGF shall be credited to SGF by the Exchange, net of income tax paid on such income.” In view of this provision, whether the income earned out of the investments of SGF should be:
(a) credited to the statement of profit and loss and amount net of tax should be charged to the statement of profit and loss, or
(b) credited to the statement of profit and loss and amount net of tax should be appropriated from profit after tax, or
(c) directly transferred to SGF without the same being routed to the statement of profit and loss.
(iii) Settlement penalties collected by the Exchange from the members:
As per revised Guidelines dated March 14, 2014, “All settlement related penalties charged by the Exchange from members will continue to be part of SGF”. In view of this provision, whether the settlement related penalties collected by the Exchange should be:
(a) credited to the statement of profit and loss and the amount net of tax* to be transferred to SGF should be charged to the statement of profit and loss, or
(b) credited to the statement of profit and loss and the amount net of tax* to be transferred to SGF should be appropriated from profit after tax, or
(c) directly transferred to SGF without the same being routed to the statement of profit and loss.
* As per FMC Guidelines, it is not explicitly stated that settlement penalties are to be transferred to SGF net of tax. However, these penalties are subject to tax and therefore, it is assumed that transfer to SGF will be net of tax as in case of other contributions for which FMC has explicitly stated net of tax.
C. Points considered by the Committee
10. The Committee notes that the basic issues raised in the query pertain to accounting for the contribution made to SGF in line with the SGF Guidelines revised upto March 14, 2014, accounting for income accruing on SGF and accounting for settlement penalties collected by the Exchange from members. The Committee has, therefore, considered only these issues and has not considered any other issue that may arise from the Facts of the Case, such as, accounting for Base Minimum Capital/deposits received from the members, accounting for the company’s obligation of guarantee settlement in case of default by its members, determination of the amount to be contributed to SGF, legal interpretation and compliances of SGF Guidelines, etc.
11. The Committee notes that the Forward Markets Commission is the regulatory authority for the Exchange in the extant case and the Commission has prescribed SGF Guidelines for the Exchange, certain features of which are as follows:
(i) The Exchange shall on quarterly basis, make the risk assessment on SGF and shall make fresh contribution to the SGF to meet the shortfall, if any, out of the revenue earned by them. The maximum contribution by an Exchange in the SGF in a year shall be up to 5% of the gross revenue (net of income tax to be paid by the Exchange). In cases where exchanges have sufficient funds available in the SGF to meet the contingent risk, then there is no need for exchanges to make any further contribution.
(ii) All the monies earmarked to SGF need to be maintained in a separate account and any income earned on the SGF contribution needs to be retained in the same account and those should not be used for any purpose other than meeting the settlement obligations.
(iii) The income accruing on the funds belonging to SGF shall be credited to SGF by the Exchange, net of income tax paid on such income.
(iv) All settlement related penalties charged by the Exchange from members will continue to be part of SGF.
(v) The Exchange shall constitute a Committee for management of SGF.
(Emphasis supplied by the Committee)
From the above features of the Guidelines and the Facts of the Case provided by the querist, the Committee notes that SGF is a pool of funds maintained by the Exchange and which is managed by a committee constituted as per the SGF Guidelines, and will be used as a fallback guarantee mechanism to meet any contingency arising due to failure of member of the Exchange fulfilling his obligation of settlement. The Committee notes that as per the SGF Guidelines, at the time of making contribution, there is a mandate only for earmarking the funds by way of contribution to SGF as a percentage of revenue, which would be used in future for the settlement obligations of the Exchange. The Committee is of the view that this requirement of earmarking of funds cannot be considered as a mandate for incurrence of any expense during a period; rather, there is a mandate only for allocation and maintenance of funds so that there are sufficient funds available in case the contingency of settlement out of the funds arises. The Committee also notes that as per the provisions of Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’, notified under the Companies (Accounting Standards) Rules, 2006, a liability/provision should be recognised when there is a present obligation involving incurrence of expenditure, arising from a past event that leaves no realistic alternative apart from settling that obligation and also involving another party to whom the obligation is owed. The Committee notes that as per the SGF Guidelines, at the time of contribution to the Fund, there is no such obligation on the enterprise for incurrence of expenditure involving another party; rather the contribution is only an allocation to a pool of funds which can be used to meet any such obligation (if any) due to default on the part of members of the Exchange in future. Accordingly, the requirement in the SGF Guidelines for contribution to SGF may be met through creation of a reserve as an appropriation of profits rather than creating a liability by a charge to the statement of profit and loss. Accordingly, such contribution to SGF should be classified as a reserve in the balance sheet.
12. With regard to the accounting for income accruing on SGF and accounting for settlement penalties collected by the Exchange from members, the Committee notes the definition of ‘income’ as per paragraph 69(a) of the Framework for the Preparation and Presentation of Financial Statements, issued by the Institute of Chartered Accountants of India and paragraph 5 of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, notified under the Companies (Accounting Standards) Rules, 2006, as follows:
Framework
“69. ...
(a) Income is increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.”
AS 5
“5. All items of income and expense which are recognised in a period should be included in the determination of net profit or loss for the period unless an Accounting Standard requires or permits otherwise.”
The Committee notes that in the extant case, the penalties collected from the members and income accruing on SGF are inflows for the company, which would be earmarked to the SGF and would be used to meet the settlement obligations of the company and, therefore, meet the definition of income as per the Framework. Accordingly, as per the above-reproduced paragraph 5 of AS 5, the gross amount of income accruing on SGF and the penalties collected should be credited to the statement of profit and loss. However, subsequently, considering the requirements of SGF Guidelines, the appropriation should be made from the net profit of an amount which is required to be earmarked to the SGF as per the SGF Guidelines.
D. Opinion
13. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9 above:
(i) The requirement in the SGF Guidelines for contribution to SGF may be met through creation of a reserve as an appropriation of profits rather than creating a liability as a charge to the statement of profit and loss. Accordingly, same should be classified as a reserve in the balance sheet, as discussed in paragraph 11 above.
(ii) and (iii) The gross amount of income accruing on SGF and the penalties collected should be credited to the statement of profit and loss. However, considering the requirements of SGF Guidelines, the amount required to be earmarked to the SGF as per the SGF Guidelines should be appropriated from the net profits, as discussed in paragraph 12 above.
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[1]Opinion finalised by the Committee on 11.12.2014.
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