BCom 3rd Year Divisible Profits and Dividends Notes Study Material
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BCom 3rd Year Divisible Profits and Dividends Notes Study Material
“……….If the Total Assets of the business at the two dates be compared, the increase which they show at the later date as compared with the earlier date (due allowance, of course, being made for any capital introduced into or taken out of the business in the meanwhile) represent in strictness of the profits of the business during the period in question….The strict meaning of ‘Profit’ is rarely observed in drawing up the accounts of firms and companies….certain assumptions have become so customary in drawing up Balance Sheet and Profit & Loss Accounts, that it may almost be said to require special circumstances to induce parties to depart therefrom…” -Fletcher Moulton, L.J., in re. Spanish Prospecting Co. Ltd. (1911)
Meaning of Profit
In the judgment given in the case of re: The Spanish Prospecting Company Limited (cited above), it has been accepted that the profit of a business in its broadest sense is the increase in the net worth of a business found by taking the amount of the assets fewer liabilities, at the end of the period and deducting thereon the assets and liabilities, at the commencement of that period (any withdrawals to be added and new capital introduced to be deducted). (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
It is to be noted that the determination of profits of a business for a particular year is of paramount importance. In case of businesses owned by Individuals and Partners, it is entirely their discretion to ascertain profits in their own way but it is not so in the case of Limited Companies. Besides shareholders of a company, there are other parties such as the Prospective Shareholders, Creditors, Lenders and Debentureholders, etc., who are interested in its profits. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
The determination of profits is also a matter of concern for Income-tax authorities as well as the Managers and Directors who are very often paid a percentage of net profits. There is not a consensus of opinion so far as the definitions of the word, ‘profits’ is concerned. Generally, there is the prevalent notion that profit means the excess of income over expenditure during a given period.
Effects of Wrong Calculations of Profits
(a) If Profits are overstated, i.e., more profits are incorrectly determined than the actual ones.
(1) If more profits are calculated incorrectly than the actual figures thereof, and accordingly, dividends are paid out of them, it will mean the payment of dividends out of capital leading to the reduction of capital without the sanction of the Court which is a contravention of section 66 of the Companies Act. For such an act, the Directors of the company will be jointly and severally liable.
(2) If dividends are paid out of capital, the assets will be consequently reduced. This will affect the interest of Debentureholders and Creditors adversely who hold these assets as security for their loans.
The reduction in the value of assets will lead to their complete exhaustion and the entire capital will thus be sunk by and by. The company will go into liquidation.
(3) If more profits are shown, the directors and managers will get more commission if such a commission is paid as a percentage of profits.
(4) If profits are inflated as a result of the overvaluation of assets, the Balance Sheet will not disclose a true and fair view of a company’s financial state of shares. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
(b) If profits are understated, i.e., less profits are incorrectly shown than the actual ones.
(1) Under-statement of profits will deprive the present shareholders of dividends to which they are entitled and thus, their interests will be adversely affected.
(2) The value of shares will fall in the market and the goodwill of the company will be adversely affected.
(3) The directors and managers will get less commission than what they are actually entitled to as a result of the understatement of profits.
(4) Under-statement of profits is usually a result of under-valuation of assets or over-valuation of liabilities and therefore, a secret reserve will be created which may be made misused by the directors and managers.
(5) Under-statement of profits is a result of window-dressing and, therefore, the Balance Sheet will not exhibit the real position of a company’s financial affairs. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Profits vs. Divisible Profits
There is some clear distinction between ‘profits’ and ‘divisible profits’. All the profits of a company cannot be said to be divisible. Only those profits which can legally be distributed to the shareholders of the company in the form of dividends are called as ‘Divisible Profits’. Two principles should be observed before the dividend is declared to the shareholders:
- Dividends must be paid according to the requirements of the Companies Act and the Articles of Association of the company. If the Articles of Association do not provide for it, it must be paid according to Clauses 80 to 88 of Table F of Schedule I appended to the Companies Act, 2013.
- In no case, a dividend should be paid at the cost of the creditors of the company.
The Clauses 80 to 88 of Table F of Schedule I are reproduced below to provide a bird’s eye-view thereof to the readers:
Clause 80. Board recommends dividends, it is declared by shareholders in a general meeting. The company in general meetings may declare dividends, but no dividend shall exceed the amount recommended by the Board.
Clause 81. Interim dividend. Subject to the provisions of section 123, the Board may from time to time pay to the member such interim dividends as appear to it to be justified by the profits of the company.
Clause 82. Transfer to reserve. (i) The Board may, before recommending any dividend, bet aside out of the profits of the company such sums as it thinks fit as a reserve or serves which shall be applicable for any purpose to which the profits of the company be properly applied, including provision for meeting contingencies or for equalizing dividends.
(ii) The Board may also carry forward any profits that it may consider necessary not to divide, without setting them aside as a reserve.
Clause 83. On the basis of paid-up capital. (i) Subject to the rights of persons, if any entitled to shares with special rights as to dividends, all dividends shall be declared and paid according to the amounts paid or credited as paid on the shares in respect whereof the dividend is paid, but if and so long as nothing is paid upon any of the shares in the company, dividends may be declared and paid according to the amounts of the shares.
(ii) No dividend will be paid on a share in advance of calls.
(iii) All dividends shall be apportioned and paid proportionately to the amounts paid or credited as paid on the shares during any portion or portions of the period in respect of which the dividend is paid; but if any share is issued on terms providing that it shall rank for dividend as from a particular date such share shall rank for dividend accordingly.
Clause 84. Deductions. The Board may deduct from any dividend payable to any member all sums of money, if any, presently payable by him to the company on account of calls or otherwise in relation to the shares of the company.
Clause 85. (i) Method of payment: Any dividend, interest, or other monies payable in cash in respect of shares may be paid by cheque or warrant sent through the post directed to the registered address of the holder or, in the case of joint holders, to the registered address of that one of the joint holders who is first named on the register of members, or to such person and to such address as the holder or joint holders may in writing direct.
(ii) Every such cheque or warrant shall be made payable to the order of the person to whom it is sent.
Clause 86. Payment to joint holders. Any one of two or more joint holders of a share may give effective receipts for any dividends, bonuses or other monies payable in respect of the such share.
Clause 87. Notice of any dividend that may have been declared shall be given to the persons entitled to share therein in the manner mentioned in the Act.
Clause 88. No interest is paid on amount payable as dividend. No dividend shall bear interest against the company.
DIVISIBLE PROFITS
It is rather difficult to give a precise definition of the term ‘Divisible Profits’. The following arguments may, however, be examined:
“Profits of the company mean profits available for recommendation and distribution as dividends after setting aside to reserve or after carrying forward such amounts as the Directors deem fit, even the whole of the profits for the year can be carried forward.” -In re: Buenos Aires Great Southern Railway Co. Ltd. vs. Preston (1947)
“Profits mean profits realized.” -The Union Bank of Allahabad Ltd. (1925)
“Profits available for Dividend” mean “net profits after making any deductions which the Directors can duly make.” -Fisher vs. Black & White Publishing Company (1901)
Different opinions are given on the subject. Even if the profits are arrived at, it is not easy to say that all of these are Divisible Profits. Thus, all profits are not and cannot be Divisible Profits. Only those which can be legally distributed amongst the shareholders are ‘Divisible Profits’.
The net profits of a business may be defined as the surplus of income for a given period over current expenditure for that period after making good any losses on floating assets and after providing depreciation on fixed assets.
The Companies Act does not lay a clear meaning of the term, “profits’. It is practically silent on the issue.
Section 123 of the Companies Act, 2013 has made provisions regarding the declaration of dividends which has made the position very much clear.
The following four considerations may govern the determination of Divisible Profits:
(1) Principles of Accountancy.
(2) Provisions of Memorandum of Association and Articles of Association,
(3) Legal Decisions, and
(4) Legal Aspect (as per the provisions of the Companies Act).
- Principles of Accountancy
Divisible Profits were calculated as a surplus of income over expenditure for a given period. For this purpose, all transactions were distinguished as capital and revenue. Such a distinction was very important from the accountancy point of view, but a modified basis is now adopted to calculate Divisible Profits and old practice has been recognized as inadequate and out of date.
To calculate Divisible Profits, the difference between assets and liabilities plus capital at the commencement of a year (i.e., net worth of a business at the beginning) is found out. If assets are more, there is surplus, otherwise there will be deficiency. Similarly, the surplus or deficiency at the end of a year is calculated after considering in connection therewith the increase or return of capital, etc. If there is a surplus, it is a profit and if there is deficiency, it is loss. This is now a well-recognized principle for the determination of profits.
So far as the valuation of assets is concerned, fixed assets are valued at cost less depreciation and similarly, floating assets are valued at cost price or market price, whichever is lower. Besides this, necessary provision is made for losses of the current year and of the years to come.
According to the Principles of Accountancy, it is not proper to distribute capital profits as dividends and it is also not advisable to distribute the profits of the current year without providing for the losses of the previous years. Principles of Accountancy also advocate that proper reserve should be created before profits are distributed among the shareholders by way of dividends.
- Provisions of Memorandum of Association and Articles of Association
These two documents are quite important and the amount of divisible profits is ascertained in accordance with the provisions of Memorandum of Association and Articles of Association which contain directions to be followed by the Directors for the determination of divisible profits. It is, however, certain that the distribution of profit, which would affect the interest of third parties or which would lead to the return of capital is against the principles and illegal.
The Directors recommend the distribution of profits as dividends after making necessary reserves and provisions as required under the provisions of Memorandum of Association and Articles of Association. This is usually the way they have to pursue.
Payment of dividends out of capital is a breach of trust and the company may require e Directors to replace it (K. Madhava vs. Popular Bank, 1970). Of course, they may cover indemnity from the shareholders who have received the dividends (Moxkam vs. Grant, 1900). Thus, in the well-known Flitcroft’s case (re: Exchange Banking Co., 1882) certain bad debts were credited to the accounts, and fictitious profits thus created were ad away as dividends. The directors were held liable.
The law will not tolerate even an indirect attempt to pay back capital by way of ends. In re: Walters, Deed of Guarantee, 1933. W guaranteed the payment of preference dividends, for a period of three years and the company agreed to pay him any sums that he might pay under the guarantee. The agreement was held to be void and W could not recover the amounts paid by him in pursuance of the guarantee.
The decisions made in the various cases have impressed upon the issue that the provisions of Articles of Association should be fully observed and anything done against these rules will be illegal. It is, thus, clear that the provisions of Articles of Association must provide a base for the determination of Divisible Profits in case of a joint stock company.
The provisions in Memorandum and Articles differ from company to company in accordance with the nature and character of the business, though, of course, arrangements made thereby are more or less similar as required by the law. Hence, nothing more can be said at this stage in this connection. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
- Legal Decisions and Legal Aspect
Besides knowing the opinion of Courts expressed in different cases, the legal aspect of the issue as provided by the Companies Act is quite important. The legal position has been made clear by the Companies Acts, 2013. The provisions of law are now a ‘must’ for all limited companies in India and serve as a guideline in the determination of Divisible Profits and distribution of dividends.
In the pages that follow, an effort has been made to explain the legal aspect of the subject along with the legal decisions so that both aspects may be comparatively studied. We proceed with the reproduction of Section 123 hereunder:
DECLARATION AND PAYMENT OF DIVIDEND
Declaration of Dividend
Out of Profits only. No dividend shall be declared or paid by a company for any financial year except out of the profits of the company for that year arrived at after providing for depreciation, or
Out of Profits of previous years. Out of the profits of the company for any previous financial year or years.
Rules Regarding Declaration of Dividend Out of Reserves
In the event of adequacy or absence of profits in any year, a company may declare dividend out of surplus of previous years subject to the fulfillment of the following conditions, namely:
(1) The rate of dividend declared should not exceed the average of the rates at which dividend was declared by it in the three years immediately preceding that year:
This rule does not apply to a company, which has not declared any dividend in each of the three preceding financial years.
(2) The total amount to be drawn from such accumulated profits should not exceed one-tenth of the sum of its paid-up share capital and free reserves as appearing in the latest audited financial statement.
(3) The amount so drawn should first be utilised to set off the losses incurred in the financial year in which dividend is declared before any dividend in respect of equity share is declared. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
(4) The balance of reserves after such withdrawal should not fall below fifteen percent of its paid up share capital as appearing in the latest audited financial statement. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
(5) A company can not declare dividend unless carried over previous losses and depreciation not provided in previous year are set off against profit of the company of the current year. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Out of money provided by governments. Dividends can be paid out of money provided by the Central Government or a State Government for the payment of dividend by the company in pursuance of a guarantee given by the Government.
Transfer to Reserves. A company may, before the declaration of any dividend in any financial year, transfer such percentage of its profits for that financial year as it may consider appropriate to the reserves of the company.
Interim dividend. The Board of Directors of a company may declare interim dividend during any financial year out of the surplus in the profit & loss account and out of profits of the financial year in which such interim dividend is sought to be declared.
Depositing the dividend amount in a scheduled bank. The amount of the dividend, including interim dividend, shall be deposited in a scheduled bank in a separate account within five days from the date of declaration of such dividend.
Payment to registered shareholders only and in cash. No dividend shall be paid by a company except to the registered shareholder of such share or to his order or to his banker and shall not be payable except in cash (which includes cheque, warrant, electronic mode).
No default should have been made in the repayment of public deposits. A company cannot declare any dividend if it has made default in the payment of deposits accepted by it or interest payable on such deposits.
Transfer of unpaid dividends in special account. Where a dividend has been declared by a company but has not been paid or claimed within thirty days from the date of the declaration by any shareholder, the company shall, within seven days from the date of expiry of the said period of thirty days, transfer the total amount of dividend which remains unpaid or unclaimed to a special account to be opened by the company in any scheduled bank. It is called the “Unpaid Dividend Account”.
The company has to, within a period of ninety days of making any transfer of an amount, to the Unpaid Dividend Account, prepare a statement containing the names, their last known addresses and the unpaid dividend to be paid to each person and place it on the website of the company, if any, and also on any other website approved by the Central Government for this purpose, in such form, manner and other particulars as may be prescribed. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
If any default is made in transferring the unpaid dividends to special account by the company it has to pay interest at the rate of 12 per cent to the members.
Any person entitled to any money transferred to above account can apply to the company for payment.
If any money transferred to Unpaid Dividend Account remains unpaid or unclaimed for a period of seven years, the company will have to transfer it to Investor Education and Protection Fund. Any person who has not received his dividend from the company can claim his amount from this Fund. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
INTERIM DIVIDEND
The following points should be considered by the Directors before declaring Interim Dividend:
(1) The assets should be properly valued.
(2) It is prudent to think of losses which might arise in future.
(3) If should be seen that the payment of Interim Dividend will not adversely affect the working capital of the company.
(4) The rates at which the dividends have been paid in the previous years should also be considered.
(5) The Directors must also take into consideration the future prospects of the profits. It may be possible that heavy losses occur in the remaining period of the year. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
(6) Cash resources should also be taken into account.
(7) The rate of interim dividend should be in proportion to the expected final dividend.
The Directors, if so empowered by the Articles of Association of the company, declare Interim Dividend after taking into consideration the above points. Since Interim Dividend is declared by the Directors, there is no necessity of calling a Meeting of the Shareholders to sanction such a payment. There is a practice on the part of Directors to seek the advice of the auditor.
Auditor’s Duty about dividends
(1) The auditor should, first of all, examine the Articles of Association to confirm that they sanction the payment of Interim Dividend.
(2) He should confirm that the profits are arrived at correctly. It means that the necessary adjustments in regard to reserve for bad and doubtful debts, depreciation, etc., have been made before arriving at the figures of current profits.
(3) He should examine the resolution of the Directors in this respect. Before passing a resolution in this respect, the Directors must take into consideration the future prospects of profits, e.g., business environments, prospects of earning profits in the years to come, etc. The auditor should give advice to Directors to declare Interim Dividend if he thinks that there is no likelihood of loss in trade in the remaining period of the year otherwise Directors and Auditor will be held liable for payment of such an interim dividend out of capital.
(4) He should verify the rate of interim dividend specially. The rate of interim dividend should usually be lower than the expected rate of final dividend as, otherwise, the value of shares in the market may fall down as a result thereof and the Goodwill of the business may be affected adversely. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
(5) It is to be examined that there is no likelihood of being heavy loss arising out of forward contracts etc., in future.
(6) It should be seen that cash resources have been taken into account while deciding to declare an interim dividend. If small cash balance is left after payment of interim dividend, the working capital would be insufficient.
(7) He should see that the payment of interim dividend is intra vires, i.e., within the powers of the company to declare it.
(8) It is to be seen that the interim dividend declared by the Directors is within the limits of financial prudence. If it is otherwise, he should mention this fact in his report. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
(9) He should ensure that the declaration of interim dividend does not in any way affect the liabilities position and the working capital.
(10) He should check the records made in the financial books for the payment of interim dividend. The payment should also be vouched.
Dividend Paid out of Capital
As is held earlier, dividend must never be paid out of capital and if the Memorandum or Articles of Association give power to the company to do so, such power is invalid. -Verner vs. General & Commercial Investment Trust Ltd. (1894)
Directors who knowingly pay dividends out of capital are personally liable to make good the amount of such dividends of the company. – Oxford Benefit Building Society (1886); re: London & General Bank (1895) re: Kingston Cotton Mill Company (1896)
But where such payment has been made on the faith of a bona fide valuation of a company’s assets, which subsequently proved to be an over-estimate, the Directors are not liable. –Stringer’s Case (1869)
It has also been made clear in the legal decisions on the subject that is dividends are received by members, knowing that they are paid out of capital, the Directors may have a right of indemnity against such members to the extent to which they have received dividend. If an interim dividend has been paid out of capital due to a bona fide mistake and the Directors want to recoup such dividend out of profits before any further dividends are paid, a member who has received such dividend cannot maintain any action against the Directors.
1. DEPRECIATION
As stated earlier, depreciation on assets must be provided for. If it is not done, the books will contain misleading records and by the time the asset becomes valueless, the company will have no resources to replace it.
LEGAL DECISIONS
Wilmar us. McNamara & Co Ltd. (1895)
(a) Depreciation on Fixed Assets. (1) It was held that a company can declare dividend out of current profits without providing for depreciation on fixed assets.
Brief Facts of the case. The company was engaged in a business of carrying mails, etc. The company made a profit of £5,816, 12 s. 6 d. for the year ended 31st July, 1894. During the year, the company did not provide for depreciation on its assets, viz., leases, Goodwill, premises, houses, vans, etc., though it had been providing for depreciation on these assets in the past.
The company passed a resolution to distribute the profit and to declare a dividend to the Preference Shareholders without providing any depreciation on its fixed assets. This was objected to by Mr. Wilmer, an ordinary shareholder who requested the Court to issue an injunction against the Directors to retain them from giving effect to the resolution.
Decision. Sterling, J., delivered the judgment and refused the injunction. It was held that the Directors of a company cannot be restrained from declaring a dividend out of the current profits on the ground that no provision has been made for depreciation on fixed assets.
Crabtree Thomas vs. Crabtree (1912)
(2) Depreciation must be provided for on power machinery or trade machinery, which is necessary in order to perform the work of the business in addition to all sums actually expended in repairing the machinery or in renewing parts.
Brief Facts of the case. A testator authorized his trustees to carry on the business and pay its profits to his wife during her lifetime. The trustees provided for depreciation at the rate of 71/2 per cent on the original cost of machinery in addition to the cost of repairs before arriving at profits. The wife of the testator contended that this ought to be disallowed. (In this case no joint stock company was involved).
Decision. “But in the ordinary course of ascertaining the profits of a business where there is power machinery or trade machinery which is necessary in order to perform the Work of the business, it is, in my opinion, essential that in addition to all sums actually expended in repairing the machinery, or in renewing parts, there should also be written-off a proper sum for depreciation and that sum ought to be written-off before you can arrive at the net profits of the business, and it is not profit until a proper sum, varying with the class of machinery, has been written-off for depreciation.” (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Verner vs. General & Commercial Investment Trust Ltd. (1894)
(b) Fixed Capital may be sunk and lost and yet the excess of current receipt over current payments may be divided, but Floating or Circulating Capital must be kept up, as otherwise it will enter into and form part of such excess, in which case to divide such excess without deducting the capital which forms part of it will be contrary to law. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Depreciation or loss of floating assets must be provided for before arriving at the profits available for dividend.
Brief Facts of the case. The trust company had an issued capital of £ 6,00,000 and had borrowed £3,00,000 on the security of debenture stock and the market value of these securities in a particular year diminished to the extent of about £ 2,40,000. It was estimated that about £ 75,000 was totally irrecoverable within any reasonable period of time. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
During the last financial year, the current income from investments had exceeded the current expenditure by more than £23,000. The question for the Court to decide was whether such excess be utilized for the purpose of dividend without making good the loss of capital amounting to £ 75,000. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Decision. It was decided that a Trust Company, subject to its Articles, may distribute dividend out of the current profits without making good the loss of capital arising from diminution in the value of its investment provided:
(i) that assets are sufficient to pay-off the liabilities, and
(ii) the Articles of Association permit.
Lee vs. Neuchatel Asphalte Co. Ltd. (1889)
(c) A Company, if permitted to do so by its Articles of Association, may distribute dividends without making good the depreciation on wasting assets. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Brief Facts of the case. The Articles of Association of the company provided that the Directors would not be bound to reserve moneys for the renewal or replacement of any lease or of the company’s interest in any property or concession. Mr. Lee on behalf of himself and other ordinary shareholders sought an injunction to prevent the Directors from distributing dividend to the Preference Shareholders without first charging depreciation on the company’s assets. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Decision. It was held that “Where the Articles of Association specially stated that it was not necessary to provide for the depreciation of wasting assets, there was nothing in the Companies Act of that country to compel the company to do so.”
According to the legal decisions given above, it will, thus, appear that depreciation on floating assets must be provided for but it is not necessary to provide depreciation on fixed and wasting assets. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Quantum of Depreciation. According to Schedule II of Companies Act, 2013, depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The depreciation amount is the cost of asset less its residual value, divided by useful life of the asset. Ordinarily the residual value of an asset is often not more than 5% of the original cost of the asset.
Depreciation amount gets increased by 50% if the asset is used for double shift and increases by 100% if it is used for three shifts.
What are useful lives to compute depreciation: The useful life of an asset is the period overwhich an asset is expected to be available for use by the company or the number production units expected to be obtained from the asset.
Part C of Schedule II gives useful lives of various tangible assets like buildings, roads, plant and machinery, furniture and fittings, motor vehicles, ships, office equipment, computers etc. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
2. PAST LOSSES
As a matter of principle, it is prudent to provide for any past losses before distributing profits to the shareholders. But there are case laws which provide contrary to this. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Legal Decisions
Ammonia Soda Co. Ltd. vs. Arthur Chamberlain & Others (1918)
It is not necessarily illegal for Directors of a company to pay dividends out of current profits without making good a debit balance of the Profit and Loss Account occasioned by losses in previous years. It may write up the debit balance of the Profit and Loss Account out of an increase in the value of its fixed assets which may arise as a result of a bona fide revaluation.
Brief Facts of the case. The Directors of the company, Mr. Chamberlain and Mr. Cocking, appreciated the value of the land held by the company to write-off a debit balance in the Profit and Loss Account which was £ 19,028. The value of land was raised in the Balance Sheet of 31st July, 1911 from £ 63,264 to £ 83.788, by the addition of a sum of £20,542. This sum was credited to a Reserve Account and used to wipe off £ 12,990 of the debit balance amounting to £ 19,028. The remainder was written-off out of net profits.
In the subsequent years, the company made profits and declared a dividend. This was a case brought by the company against the Directors making them liable to refund all money paid away as dividend which was improperly paid.
Decision. It was held that the revaluation of the land was bona fide and that Directors were not liable to refund any of the dividends. The Court was satisfied that the Directors acted honestly. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Stapley vs. Read Bros. Ltd. (1924)
A company which has excessively written down its assets out of profits in the previous years may write up such assets again to the extent of such excess and apply such an amount for paying dividends. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Brief Facts of the Case. In 1918, the company had written-off its Goodwill which was then standing at £ 51,000 against a Reserve Account which had been built up out of profits. In two years, 1921 and 1922, there were losses resulting in a debit balance on Profit and Loss Account of £ 25,500. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
In 1923, there was a profit of £ 13,430 but since it was not sufficient to pay the dividend on the Preference Shares for the year 1923, and the arrears for 1921 and 1922, the Directors proposed to redebit Goodwill Account with £ 40,000 and to credit this sum to a Reserve Account and thus, to write-off the former debit balance of Profit and Loss Account by transfer to the Reserve Account.
The Court was moved to restrain the Directors from treating as profits available for distribution any profits previously used for writing-down the company’s assets subsequently written back. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Decision. In the course of his judgment, Russell, J., said, “…In my opinion, unless there is anything in the Companies (Consolidation) Act, 1908 or in the constitution of the company to prohibit it, the shareholders may, if they think fit, write back to Profit and Loss Account so much of the depreciation written-off, Goodwill as has proved to have been in excess of proper requirements.”
Thus, it will appear from the judgment given above that it is not necessary to make provision for past losses before distributing profits as dividends. These decisions do not hold good now in India as under section 123, past losses must be set-off against profits of subsequent years.
3. CAPITAL PROFITS
Capital Profits are not ordinary profits. They arise out of a bona fide revaluation of fixed assets or from receipt of premium on issue of shares, etc. Ordinarily, therefore, such profits are not made available for distribution as dividends; but they can be so distributed under certain conditions. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Legal Decisions
Lubbock vs. The British Bank of South America (1892)
If the Articles of a company so permit, a profit made on the sale of a part of its undertaking is available for dividend.
Brief Facts of the case. The Bank was set up to carry on business in Brazil and other countries. It sold its Goodwill and property in Brazil to another bank for £ 8,75,000 and earned a net profit to the extent of about £ 2,05,000. The Directors of the Bank wanted to credit the Profit and Loss Account with this sum and to pay dividends to its shareholders.
Decision. Under the Articles, the Directors were justified in carrying over the sum of £ 2,05,000 to the Profit and Loss Account and having appropriated to the Reserve Fund so much of the sum as they thought fit, they could distribute the balance as dividends. It was plainly profit on capital and not part of the capital itself and hence, the Directors could distribute it by way of dividends to the shareholders.
Foster vs. The New Trinidad Lake Asphalte Company Ltd. (1901)
Capital Profits cannot be distributed as dividends unless all other assets have been revalued, depreciation has been provided for, such profits are actually realized and the Articles of Association permit. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Brief Facts of the case. In this case, a debt of £ 1,00,000 (shown as an asset) was written-off as irrecoverable. Subsequently, it was received in full, together with interest accrued, realizing £ 26,258 16s. The amount received was treated as a profit. The Directors proposed to distribute it as dividend. This was objected to by the Debentureholders.
Decision. It was held that a realized appreciation in the value of a book debt cannot be distributed as dividend unless surplus remains after a revaluation of all the assets. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
Ammonia Soda Co. Ltd. vs. Arthur Chamberlain & Others (1918)
A company can set-off an appreciation in value of the Capital Assets as ascertained by a bona fide valuation against losses on Revenue Accounts.
On the basis of judgments delivered in the above case, it can be laid down that the Capital Profits can be distributed as dividends, if
(i) the Articles of a company permit;
(ii) such profits are realized in cash;
(iii) they remain after a proper valuation of all the assets; and
(iv) capital losses have been made good.
A capital appreciation cannot be made available for distribution by way of dividend but can be transferred to Capital Reserve Account.
It is, however, to be noted that in the case of Dimbula Valley (Sri Lanka) Tea Co, Ltd vs. Lausie (1961) (AII E.R. 769). Buckley, J., expressed the view that a surplus on capital account resulting from a bona fide revaluation made by competent valuers was available for paying up bonus shares to be issued to the members even though it was not realized. The judge did, however, point out that a distribution from such a source would not be normally regarded as wise from the commercial point of view.
Legal Position
Section 123 of the Companies Act simply lays down that no dividend shall be paid except out of the profits of a company and hence, Capital Profits may also be made available for dividend provided the above-mentioned conditions in the judgement cited above are fulfilled.
4. CAPITAL LOSSES
Legal Decisions
Bolton vs. Natal Land and Colonization Co. Ltd. (1892)
A company may declare a dividend out of current profits without making good the Capital Losses.
Brief Facts of the Case. In the year 1882, the company charged to its Profit and Loss Account £ 70,000 in respect of bad debts while a similar sum representing an increase in the value of lands held by the company was credited in the Profit & Loss Account. In 1885, a profit was made and a dividend was subsequently declared. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
The basis of the case was that the Directors should be restrained from paying the dividend on the ground that the value of the land was far below its book value and the difference must be charged to Profit & Loss Account before arriving at profits available for dividend.
Decision. In the opinion of the Court, “assuming that a part of the capital had in fact been lost and not subsequently made good, no sufficient ground was thereby afforded for restraining the payment of dividend; that the fact of the company having written up the value of their lands in 1882 and credited the increase to the profit of that year in the manner described, did not place them under obligation to bring into account every subsequent year the increase or decrease in the value of their lands.”
Verner vs. General & Commercial Investment Trust Ltd. (1894)
Fixed Capital may be sunk or lost and yet the excess of current receipts over current payments may be distributed as dividend. Thus, dividends can be distributed out of the surplus without making good the loss of capital.
Thus, it will appear that it is not necessary to make good the loss of capital before distributing profits as dividend.
5. COMPULSORY RESERVES
Under Clause 82 of Table F, the Board may, before recommending any dividend, set aside out of the profits of the company such sums at it thinks proper as a reserve or reserves which shall, at the discretion of the Board, be applicable for any purpose to which the profits of the company may be properly applied (including provision for meeting contingencies or for equalizing dividends) and pending such application, may, at the like discretion, either be employed in the business of the company or be invested in such investments (other that shares of the company) as the Board may, from time to time, think fit. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
The Board may also carry forward any profits which it may think prudent not to divide without setting them aside as a reserve.
Under section 123 of the Companies Act, 2013, it has been provided that dividend shall be declared or paid by a company for any financial year out of the profits of the company for that year arrived at after providing for depreciation and after the transfer to the reserves of the company of such percentage of its profits for that year as directors think appropriate.
6. OTHER ISSUES TO BE CONSIDERED
A company cannot distribute profits earned on the redemption of debentures, if the Articles do not provide contrary to this. -Wall vs. The London & Provincial Trust Co. Ltd. (1919)
A company may pay dividends out of current profits when a debit balance on Profit & Loss Account has been wiped off by writing back to the credit of Profit & Loss Account an amount of Goodwill previously written-off out of profit. (Already discussed earlier) -Stapley vs. Read Brothers Ltd. (1924)
Auditor’s Duty
The question of Divisible Profits is peculiar in the sense that it depends to a large extent on the circumstances of a particular case. The auditor should see that the legal decisions and legal aspects of the issue have been properly complied with. He should examine the question on the basis of general principles and norms explained earlier, a summary of which is given hereunder:
(1) No dividend is to be paid except out of profits, i.e., excess of income over expenditure.
(2) Capital Profits may be divisible, if
(i) Articles provide,
(ii) such profits are realised in cash,
(iii) they remain after a bona fide revaluation of all the assets,
(iv) Capital Losses are made good.
(3) Revenue Losses must be made good before Revenue Profits are distributed, i.e., dividends must not be paid or declared if there is a debit balance of Profit and Loss Account. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
(4) Capital Losses must be made good before Capital Profits are distributed.
(5) Capital Losses need not necessarily be made good before Revenue Profits are distributed.
(6) Past losses need not necessarily be made good but to the extent and in the manner as laid down by section 123 of the Companies Act.
(7) If any asset (Goodwill or other) has been excessively written-down in the past, the excess may be written back to the Profit and Loss Account and thus, made available for distribution as dividend.
(8) The Board of Directors may set aside a certain sum of money to reserve or reserves as under Clause 82 of Table F appended to the Companies Act. (BCom 3rd Year Divisible Profits and Dividends Notes Study Material)
The auditor should see that these provisions are fully complied with and if it is not done, he is at liberty to mention this fact in his report to be submitted to the shareholders. The auditor has no more liability than this.
BCom 3rd Year Divisible Profits and Dividends Notes Study Material
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