MCom I Semester Corporate Accounting Underwriting Study Material Notes

MCom I Semester Corporate Accounting Underwriting Study Material Notes: Payment of Inderwiting Commission Brokerage Determining the Liability of Inderiters Maximum limit of Brokerage Determining Underwriters Liability Case Partial Underwriting Journal entries Discussion Questions Long Answer Questions Short Answer Questions :

CTET Paper Level 2 Language II Model paper in English

Underwriting

When shares or debentures are issued by a public limited company, it wants that its issue is fully subscribed by the public. In case the company fails to get even the minimum subscription on its issue then it would not have the right of allotment of these shares or debentures and in such a case, it has to refund to the applicants their application money. If the company issues the shares for the first time and fails to receive minimum subscription, it would not be granted the certificate to commence business. So, in order to ensure minimum subscription, the companies usually resort to underwriting.

Underwriting may be defined as an agreement entered into by the company with certain person, persons or institutions, called underwriters, who undertake the responsibility and give guarantee that the shares or debentures underwritten by them will be subscribed for in full by the public and in case of under subscription they will take the shortfall. In consideration of undertaking such responsibility, the remuneration which the underwriters get from the company is called the underwriting commission,

Underwriting Study Material Notes

Payment of Underwriting Commission

Underwriting commission is determined on the basis of a contract entered into by the company with the underwriters. As per the terms of the contract, such a commission is paid at a specified rate on the issue price (or on face value, if the agreement so provides) of the whole of the shares or debentures underwritten whether or not the underwriters are called upon to take any shares or debentures. It may be paid in cash, shares or debentures or partly in one form and partly in another form. In the books of the company, such expense may be written off against its undistributed profits, future profits or share premium and until it is written off, it is shown in the assets side of the Balance Sheet under the heading ‘Miscellaneous Expenditure

Section 76 of the Companies Act, 1956 lays down the following conditions for the payment of underwriting commission:

1 the payment of commission is authorized by the Articles;

2. the commission paid or agreed to be paid does not exceed – (a) in the case of shares, 5% of the issue price of shares or the amount or rate authorised by the Articles, whichever is less, and (b) in the case of debentures, 2 1/2% of the issue price of debentures or the amount or rate authorised by the Articles, whichever is less;

3. no underwriting commission can be paid if the issue is privately placed, i.e. it is not offered to the general public;

4. the amount or rate of commission should be disclosed in the Prospectus or Statement in lieu of Prospectus, as the case may be.

5. a copy of the contract relating to the payment of the commission should be delivered to the Registrar.

Underwriting Study Material Notes

Brokerage

Brokerage is paid to the brokers in consideration of their procuring subscription for shares or debentures issued to the public. Brokers are entitled for brokerage at a specified rate on shares or debentures subscribed by the public through them but they are under no obligation for any shortfall in subscription. Brokerage is paid in addition to the underwriting commission under Section 76.

The main difference between the brokerage and commission is that brokerage is paid for the service of placing the shares or debentures before the public whereas underwriting commission is paid for the guarantee of subscription in full. Hence, a broker is free from the risk of under-subscription whereas an underwriter has to take up himself the shortfall in public subscription.

Current Rates of Underwriting Commission, Brokerage and Remuneration of Managers to the Issue

Pursuant to Guidelines issued by the Stock Exchange division of the Department of Economic Affairs, Ministry of Finance, the following rates for payment of underwriting commission, brokerage and remuneration of Managers to the Issue, are in force :

Note : Underwriting commission will not be payable on amounts taken up by the promoters group, employees, directors, their friends and business associates.

2. Maximum Limit of Brokerage :

(i) Brokerage applicable to all types of public issues of industrial securities is fixed at 1.5% whether the issue is underwritten or not;

(ii) The mailing cost and canvassing expenses of brokers will be borne by the brokers themselves;

(iii) The listed companies are allowed to pay brokerage on private placements of capital at the maximum rate of 0.5 percent;

(iv) Brokerage will not be allowed in respect of promoters’ quota, including the amounts taken by the directors, their friends and the employees and the right issues.

(v) Brokerage will not be paid when the applications are made by the institutions/banks against their underwriting commitments or on the amounts devolving on them as underwriters consequent to under subscription of the issues.

3. Maximum Fees of the Managers to the Issue : The companies are free to appoint one or more agencies as managers to the issue but the aggregate amount payable as fees to such persons shall not exceed the following limits :

(i) For issues upto Rs. 5 crores :                           0.5 per cent

(ii) For excess over Rs. 5 crores :                         0.2 per cent

Further, they shall not be paid for the following:

(a) Amounts agreed to be taken up by the financial institutions and the amounts devolving on the financial institutions as investors/underwriters.

(b) Promoter’s quota of capital, including the amount taken up by the employees, directors, their friends and the business associates.

(C) On amounts subscribed on rights basis.

Full (or Complete) Underwriting and Partial Underwriting

Underwriting may be full or partial. If the company enters into a contract for underwriting the whole issue of shares or debentures, it is called as full or complete underwriting ard if the company enters into a contract for underwriting a part of the total issue then it is called as partial underwriting. In case of partial underwriting, the rest part of the issue is sold by the company itself. Whether it is full underwriting or partial, in both cases underwriters may be one or more than one.

Marked and Unmarked Applications

Applications bearing the official stamp of an underwriter or broker are called ‘marked applications while the applications received by the company which do not bear any stamp of underwriters or brokers are called ‘unmarked applications’.

If the entire issue is underwritten by only one underwriter, the marking of applications is immaterial because he will get credit of all the applications whether sent through him or received by the company directly. But if the underwriters are more than one or underwriting is partial, marking of applications becomes material for determining the underwriting liability of the underwriters. Marked applications reflect personal efforts of the underwriters, each underwriter gets credit for his own marked applications and unmarked applications reflect common efforts of all the underwriters, all the underwriters get credit for these applications on some appropriate basis.

Underwriting Study Material Notes

Determining the Liability of Underwriters

The liability of the underwriters is determined in various cases as follows:

Determining Underwriters’ Liability in case of Complete Underwriting

If the whole issue is underwritten only by one underwriter, his net liability will be determined by deducting both marked and unmarked applications from his gross liability (i.e. shares underwritten). As such, he will be liable only such shares or debentures which are not subscribed for by the public.

If the whole issue is underwritten by two or more underwriters, the procedure for determining the underwriters liability will be as follows:

(i) Determine the gross liability of each underwriter. It is either given in the question clearly or it may be calculated according to agreed ratio.

(ii) Deduct the marked applications of each underwriter from his gross liability and find the balance left.

(iii) Deduct each underwriter’s share in unmarked applications from the balance left as calculated in (ii)

above, the balance will be the net liability of each underwriter.

The share of each underwriter in unmarked applications may be determined as per the terms of agreement either (a) in the ratio of their gross liability or (b) in the ratio of balance left as calculated in (ii) above. If the question is silent over this term then the students may follow any of the two bases but they should append a note specifying their basis. In our opinion ratio of gross liability is more logical. (iv) If as a result of above (ii) and (iii), there is any excess of any underwriter (i.e. his balance is in minus) then in the absence of any direction otherwise, this excess should be transferred to other underwriters’ accounts in the ratio of gross liability interse. After this adjustment, net liability of each underwriter on account of shortfall in the public subscription is known.

Illustration 1. On January 1, 2001, X Ltd. issued a prospectus for issuing 1,00,000 Equity Shares. Whole of the issue was underwritten as below:

Rama                              40,000

Shares Krishna          30,000

Shiva                               20,000

Brahma                         10.000

Applications were received for 90,000 shares out of which following were marked :

Rama                                30,000

Krishna                           25,000

Shiva                                16,000

Brahma                            9,000

Calculate the liability of each underwriter.

Determining Underwriters’ Liability in case of Partial Underwriting

when only a part of total issue is underwritten, it is called partial underwriting. That part of total issue which is not underwritten is said to have been underwritten by the company itself. In this type of underwriting, the underwriters are given credit for marked applications only and the company gets credit for unmarked applications. If the information as to the marked applications and unmarked applications is not given in the problem then total applications will be divided among the underwriters and the company in the ratio of their gross liability.

If there is only one underwriter then his liability will be determined by deducting the marked applications from his gross liability but his net liability will be limited to the extent of total shortfall in public subscription. For example; if A has underwritten 60% of the issue of 10,000 shares of Sun Ltd. The company received 4,000 marked and 5,000 unmarked applications. In this case, the liability of the underwriter is for 2,000 shares (60% of 10,000 – 4,000) but his net liability will not exceed total shortfall in subscription, i.e. 10,000 – 9,000 = 1,000 shares. The reduction in his liability is on account of excess unmarked applications (40% of 10,000 – 5,000 = 1,000 shares) of the company.

If the underwriters are two or more, then each underwriter’s liability will be determined by deducting his marked applications from his gross liability. Relief is given to all underwriters for the excess unmarked applications of the company, if any, in the ratio of their gross liability (or gross liability as reduced by marked applications).

Illustration 3. P Ltd. issued 1,20,000 shares of Rs. 10 each of which 80% was underwritten by

A, B and C in the following manner – A-30% B-50% and C-20%

The company received applications for 1,00,000 shares in all, out of which marked applications were:

A-20,000 shares, B-30,000 shares and C – 10,000 shares.

Find out the liability of each underwriter.

Solution :

Total shares underwritten = 80% of 1,20,000 = 96,000

Shares to be sold by P Ltd. itself = 1,20,000 — 96,000 = 24,000

Unmarked Applications = 1,00,000 – (20,000 + 30,000 + 10,000) = 40,000

shares P Ltd’s excess = 40,000 – 24,000 = 16,000

Statement Showing Underwriters’ Liability

A

B

C

D

 

Gross Liability (Shares underwritten) (30:50:20)	28,800	48,000	19,200	96,000
Less Marked Applications	20,000	30,000	10,000	60,000
Balance left	8,800	18,000	9,2000	36,000
Less Relief for Co.’s excess applications (30:50:20)	4,800	8,000	3,200	16,000
Net Liability	4,000	10,000	6,000	20,000

Underwriting Study Material

Firm Underwriting

It is a commitment made by the underwriters to make an outright purchase of certain number of shares or debentures underwritten firm out of their own underwritten shares or debentures. In such a case, if the issue is over-subscribed, shares underwritten as reduced by shares underwritten firm will only be allotted to the public and the underwriters will take the shares underwritten firm by them. If the issue is undersubscribed, the underwriters’ total liability will be the sum of net liability under underwriting contract and the shares underwritten firm. It is to be noted that unless stated otherwise firm applications will be deemed to have been included in the marked applications, as each such applications will have the stamp of the concerned underwriter.

Entries in the Books of the Company

The underwriters are entitled for underwriting commission on total number of shares or debentures underwritten by them whether or not the issue is fully subscribed for by the public. Underwriting commission is an expenditure of capital nature and can be written off against premium on issue of shares or debentures. If no such premium is available, then it can be written off over a number of years against Profit and Loss Account. The amount of commission not so written off is shown each year in the assets side of Balance Sheet under the heading Miscellaneous Expenditure’.

(1) On underwriting commission becoming due :

Underwriting Commission Account                                  Dr.

To Underwriters Account

(2) On payment of underwriting commission :

Underwriters Account                                                           Dr.

To Cash/Bank Account

To Share Capital Account (if shares issued)

To Debentures Account (if debentures issued)

To Share Premium Account (if shares issued at premium)

To Premium on Debentures Account (if debentures issued at premium)

(3) If the issue is under-subscribed and shares or debentures are allotted to the underwriters in respect of their liability :

Underwriters Account                                                     Dr.

To Share Capital Account

To Share Premium Account         (if any)

To Debentures Account

To Premium on Debentures, Account (if any)

(4) On receiving payment from the underwriters :

Bank Account                                                                   Dr.

To Underwriters Account

Note : Underwriting commission is not generally paid in cash. Instead the same is adjusted against the money due on shares or debentures taken up by the underwriters and only the net amount is received from or paid to the underwriters. If this procedure is followed, entry (2) will not be passed and the entry (4) will be passed with the balance of (1) and (3).

(5) On writing off the amount of underwriting commission :

Share Premium Account

Or Profit and Loss Account                   Dr.

To Underwriting Commission Account

Illustration 7. Krishna underwrote the new issue of 5,000 shares of Rs. 100 each of Rama Company Ltd. The agreed commission was 5%, payable in cash. The public subscribed for 3,000 shares only and rest of the shares had to be taken by the underwriters:

Give Journal entries in the books of the company.

For finding out profit or loss in Underwriting Business The Accounts of the Underwriters can Be Prepared in two ways :

1 Opening one account only in underwriters’ books.

2. Opening several accounts in underwriters’ books.

3. When only one account is opened in underwriters’ books

Underwriting Study Material

In this method only one account entitled ‘Underwriting Account’ (or Investment in Shares/Debentures Account) is opened in underwriters’ books. This account is in the nature of profit and loss account and shows profit or loss under underwriting contract. This account is prepared as follows:

(2) On receiving shares or debentures – When an underwriter is allotted shares or debentures under underwriting contract and/or firm underwriting, the following entry is passed :

Underwriting Account                  Dr. with the amount paid

To Bank Account

Sometimes, the issuing company demands from the underwriters full application money on all shares debentures underwritten. In such a case, at first the underwriter will pay on application full application

Money on shares or debentures underwritten. Afterwards on becoming the position of public subscription clear, the underwriter will pay allotment money on shares or debentures allotted to him after adjusting the excess amount of application.

(ii) On incurring underwriting expenses –

Underwriting Account                         Dr. with the amount of expenses paid

To Bank/Cash Account

(iii) On receiving the underwriting commission – As per the terms of agreement, the underwriting commission may be received in cash, shares or debentures and the following entry is passed :

Bank Account                      Dr. (with the cash received)

Underwriting Account           Dr. (with the shares or debentures received)

To Underwriting Commission Account (with the total commission) The underwriting commission should not be treated as income of the underwriter; it should be treated as reducing the amount paid for shares or debentures acquired under underwriting agreement and so the following entry is passed for transferring the Commission Account: Underwriting Commission Account Dr. with the total of Commission Account

To Underwriting Account If the whole commission is received in cash then instead of passing the two entries as above in

(iii), only one entry may be passed as follows:

Bank Account                   Dr. with the total commission received

To Underwriting Account

As is clear from the above entries, when underwriting commission is received in the form of shares or debentures, it is shown on both sides of Underwriting Account; on the debit side the number and amount both are shown whereas on the credit side only the amount is shown.

(iv) Dealing in Shares or Debentures – Shares or debentures received by the underwriter are his stock-intrude and he sells them on appropriate opportunity. If any dividend or interest is received before their disposal, it is shown on the credit side of Underwriting Account. But if bonus shares are received, only the number of bonus shares received is shown on the debit side of Underwriting Account but on receiving right shares, the number of shares and the amount paid for them both are shown on the debit side of Underwriting Account.

On disposal of shares or debentures, the following entry is passed :

Bank/Cash Account                                   Dr. with the net sale proceeds

To Underwriting Account

(v) Valuation of unsold shares or debentures – At the end of the accounting year, the shares or debentures remaining unsold with the underwriter are valued at cost or market price, whichever is lower. Cost here means the average cost. If market price is lower, Underwriting Account will show loss and it will be transferred to Profit and Loss Account. The Underwriting Account will show profit only when the sale proceeds of shares or debentures exceeds the total cost of investment. If some shares or debentures are left after recovering the total cost, then the balance of such shares or debentures is carried forward at zero cost. Note : Generally profit on sale of a part of shares or debentures is not calculated and net sale proceed reduces the cost of the remaining shares or debentures but if the underwriter intends to keep these shares or debentures for long period and there is no possibility of fall in their price then profit on sale of a part of shares or debentures may be transferred to Profit and Loss Account.

Illustration 12. Ramesh underwrites an issue of 10,000 shares of Rs. 10 each of B Ltd. in consideration of a commission of 2% payable in cash. The public subscribed for 9,000 shares only and Ramesh has to take up the remaining shares. His expenses amount to Rs. 100. When he closes his accounts for the year, no shares were sold and market value on that date was Rs. 7.50 per share. Next year Ramesh sold 800 shares

Discussion Questions

Long Answer Questions

1 What do you mean by underwriting of shares and debentures ? What are various provisions in Companies Act regarding underwriting commission ? Mention accounting problems regarding underwriting.

2 Write short notes on :

(a) Underwriting

(b) Calculation of liability of underwriters

(c) Overriding Commission

(d) Sub-Underwriting

3. What do you understand by firm underwriting ? What is the maximum commission that can be legally paid ?

4. What do you understand by Underwriting, Sub-Underwriting, and Firm Underwriting?

Underwriting Study Material

Short Answer Questions

(i) What is underwriting? State provisions of Companies Act regarding underwriting commission.

(ii) What is the overriding commission? Why is it paid?

(iii) What is underwriting? How the liability of underwriters is determined in case of partial underwriting?

(iv) What is firm underwriting? How does it affect the determination of the underwriter’s liability?

(v) How underwriting transactions are accounted for in the books of the underwriters?

(vi) Explain in brief sub-underwriting,

Numerical

(i) C Ltd. issued 1,00,000 shares for public subscription and these were underwritten by A, B and C in the ratio of 25%, 30% and 45% respectively. Applications were received for 80,000 shares and of these applications for 16,000 shares had the stamp of A, those for 20,000 shares had the stamp of B and those for 24,000 shares had the stamp of C. The remaining applications did not bear any stamp. On the basis of above information, work out the liability of the individual underwriters.

(Answer: A=4,000; B = 4,000; C = 12,000) (ii) Anshu Ltd. made a public issue of 2,50.000 equity shares of Rs. 10 each, the entire amount payable on

application. The entire issue was underwritten as follows: Red – 30%, Yellow – 25%, Green – 25% and White – 20% of public issue respectively. Red, Yellow, Green and White had also agreed on firm underwriting of 8,000, 12,000, nil and 30,000 shares respectively. The total subscriptions excluding firm underwriting, including marked applications were 1,80,000 shares.

The marked applications received were as under:

Underwriter	No of Shares
Red	48,000
Yellow	40,000
Green	24,000
White	48,000

 

Ascertain the net liability of each underwriter.

(Answer: Red-Nil; Yellow – Nil, Green – Rs. 20,000; White – Nil)

 (iii) Mitthu Ltd, made an issue of 10,000. 10% mortgage debentures of Rs. 100 each at Rs. 96. The whole of the issue was underwritten by Smart Bulls. 8,500 debentures were applied for and allotted to the public. The underwriters discharged their liability and were paid commission at the rate of 2% on the nominal value of the debentures. Show the journal entries.

(Answer: Shortfall took by underwriters 1,500 shares: Net payment from underwriters Rs. 1,24,000)

 

Underwriting Study Material