Divisible Profits and Dividends
The portion of profit, which can legally be distributed to the shareholders of the company by way of dividend, is called the ‘divisible profit’.
The term ‘divisible profit’ has nowhere been defined in the Companies Act, neither the act states what is meant by ‘profit’. Only Section 205 of the act lays down that no dividend can be declared or paid by a company except out of current profits or past undistributed profits or both, arrived at after providing for depreciation or money provided by the government for payment of dividend in pursuance of a guarantee given by the government.
10.2 MEANING OF DIVIDEND
The dictionary meaning of ‘dividend’ is “sum payable as interest on loan or as profit of a company to the creditors of an insolvent’s estate or an individual’s share of it.” But in commercial usage, however, dividend is the share of the company’s profit distributed among the members. So, corporate earnings and profits not retained in the business and distributed among the shareholders is known as dividend. The term ‘dividend’ is also used to include distribution of the company’s assets, in cash or in specie, which remain with the liquidator after he has realised all the assets and discharged all the liabilities, in the event of its winding up.
In Commissioner of Income Tax vs Girdhar Das & Co. (P) Ltd. 1967 case, the Supreme Court defined the expression ‘Dividend’ as follows:
“As applied to a company which is a going concern, it ordinarily means the portion of the profit of the company which is allocated to the holders of shares in the company. In case of winding up, it means a division of the realised assets among creditors and contributories according to their respective rights.”
Before introduction of Sub-section (14A) in Section 2 of the Companies Act, the term was not defined. At present, according to this section, dividend includes any interim dividend. This definition assumes that the term should be understood only in its commercial sense.
The Institute of Chartered Accountants of India has defined dividend in its Guidance Notes on Terms used in Financial Statements as “a distribution to shareholders out of profits or reserves available for this purpose”.
10.3 CONCEPT OF PROFIT
The main objective of any business organisation is profit, but the term ‘profit’ does not have any exact meaning in the accountant’s language. Profit may be defined “as the increase in the net value of assets of a business over their net value at the commencement of a given period which has arisen other than by capital adjustment”.
According to the viewpoint expressed by the court in the case Spanish Prospecting Co. Ltd. (1911), “the profit of an enterprise can be ascertained by computing the market value of its net assets at two accounting dates. The increase or decrease in the net worth is the profit or loss for the intervening period”.
The Institute of Chartered Accountants of India has defined ‘profit’ in its Guidance Notes on Terms used in Financial Statements as “the excess of revenue over related costs”.
10.4 PROFIT VS DIVISIBLE PROFIT
All the profits of a company cannot be said to be divisible. Only those portions of the profit, which can be legally distributed to the shareholders of the company in the form of dividends, are called as divisible profits. A number of factors are required to be considered for the determination of divisible profit. Out of different important factors, the following four considerations govern the determination of divisible profit to a great extent:
- Accounting principles
- Provisions of the Companies Act
- Provisions of the Memorandum and Articles of Association
- Legal judgments
10.5 PRINCIPAL DETERMINANTS OF DIVISIBLE PROFIT
Several matters influence the determination of divisible profits. These arise from the provisions of law, case laws, provisions in the articles of association of the company and the principles and policies involved in the determination of true and fair amount of profit.
Section 205 of the Companies Act contains provisions relating to declaration of dividend and ascertainment of divisible profit. There are also certain provisions elsewhere in the act connected with the question of divisible profit. All these provisions are stated in the following paragraphs.
1. Profit after providing for depreciation
Dividend can be paid by a company only out of current profits and past profits remaining undistributed, both arrived at after providing for depreciation in accordance with the provisions of the Companies Act. However, the central government may, if it thinks necessary to do so in the public interest, allow any company to declare or pay dividend for any financial year out of the profits of the company for that year or any previous financial year or years without providing for depreciation.
As to how much depreciation should be provided for determining the divisible profit, Section 205(2) provides that depreciation must be provided in any of the following ways:
- To the extent specified in Section 350
- In respect of each item of depreciable asset, for such an amount as is arrived at by dividing 95% of the original cost by the specified period
- On any other basis approved by the central government by which 95% of the original cost of each such depreciable asset can be written off on the expiry of the specified period
- In respect of other depreciable assets for which no rate of depreciation has been laid down by the act or the rules made there under, on such basis as may be approved by the central government by general or special order
Dividend can also be paid out of money made available by the central or state government for the payment of dividend in pursuance of a guarantee given by the government.
3 Arrear depreciation
If there is any arrear depreciation is respect of past years, it must be provided for out of current or past profits, before paying dividend for any financial year. In other words, where a company has not provided for depreciation for any financial year after the commencement of the Companies (Amendment) Act, 1960, this should be done before any dividend is declared. Such arrears of depreciation may be provided out of current profits or the profits of the previous financial years, remaining undistributed.
4. Past losses
Any past loss of the company must be set off against current or past profits or on both to the extent required by the Companies Act, before paying dividend for any financial year. Where a company has incurred any loss in any previous financial year or years falling after the commencement of the Companies (Amendment) Act, 1960, then the lower of the following two amounts should be set off:
- The amount of the loss
- The amount of depreciation provided for that year or those years.
The amount should be set off against the following.
- The profits of the company for the year for which dividends are proposed to be declared or paid, or
- The profits of the company for any previous financial year or years arrived at after providing for depreciation
- Both (i) and (ii) mentioned above.
5. Exemption from depreciation
The central government may in the public interest allow any company to pay dividend out of current or past profits without making provisions for depreciation.
6. Transfer of profits to reserves
The current profit of a company arrived at after providing for depreciation can be applied for the payment of dividend only after transferring to reserves such a percentage of profit not exceeding 10% as may be prescribed by the central government.
After the commencement of the Companies (Amendment) Act, 1974 a company is required to transfer a prescribed percentage of its profit to its reserves before declaring dividend. However, there is no bar on a company to voluntarily transfer a higher percentage of its profits to the reserves in accordance with such rules as may be made by the central government in this context.
Table 10.1 depicts the prescribed rates of profit to be transferred to reserve according to the Transfer to Reserve Rules, 1984 as framed by the central government:
|Rate of proposed dividend||Amount to be transferred to reserves|
Exceeding 10%, but not 12.5%
Not less than 2.5% of current profit
Exceeding 12.5%, but not 15%
Not less than 5% of current profit
Exceeding 15%, but not 20%
Not less than 7.5% of current profit
Not less than 10% of current profit
However, no amount is required to be transferred to reserves, where the rate of proposed dividend is 10% or less.
7. Dividend from reserves
Dividend can be paid out of the accumulated past profits of a company kept in reserves in accordance with the rules framed by the central government in this regard or with the previous approval of the central government: Section 328(3). Section 205(3) inserted by the Companies Act, 1974 requires that dividend can be declared out of reserves only in accordance with the rules framed by the central government in this behalf. However, where a company wishes to declare a dividend otherwise than as per these rules, it may do so with the prior approval of the central government. The credit balance, if any, showcased in the profit and loss account will be available for declaration of dividend without restriction if such balance was carried after charging depreciation, tax etc. in the previous year(s).
The rules framed by the central government in this regard provide that in the event of absence or inadequacy of profits in any year, dividend may be declared by the company out of accumulated past profits provided the following conditions are satisfied:
- The rate of dividend declared does not exceed the average of the rates at which dividend was declared by it in the five years immediately preceding that year or 10% of its paid-up capital, whichever is less.
- The total amount to be drawn from the accumulated profits earned in previous years and transferred to the reserves does not exceed an amount equal to one-tenth of the sum of its paid-up capital and free reserves and the amount so drawn must first be utilised to set off the losses incurred in the financial year before any dividend in respect of preference or equity shares is declared.
- The balance of reserves after such withdrawal does not fall below 15% of its paid-up share capital.
- The amount in no way possible should be used to pay interim dividend.
8. Distribution of profit out of capital redemption reserve account
If capital redemption reserve is created against redemption of preference shares, no dividend can be paid from this reserve in future (Section 80).
9. Premium on redemption
The premium payable on redemption of preference shares shall be provided for out of the profits of the company or out of the securities premium account (Section 80).
- Provision for taxation No part of the net profit from business can be appropriated for payment of dividend without making necessary provision for taxation, as payment of income tax from business earnings is a legal obligation.
- Dividend out of capital profit Except securities premium, profit from forfeiture of shares and profits prior to incorporation, capital profits can be applied for payment of dividend, subject to certain conditions, which include the following:
- Such profits must be realised profits
- The Articles of Association of the company shall not contain any prohibitive provision relating to distribution of such profits as dividend and
- Such profits must remain as a surplus after revaluation of all the assets of the company.
- Capital losses, intangible assets and ficticious assets According to the accounting and commercial principles capital losses, intangible assets and ficticious assets should be written off from profits over a reasonable period and a company should have definite policies in respect of such writing off. Application of profit for payment of dividend can arise only after such regular annual write off.
- Transfer of additional profits to reserve The Directors of a company are empowered to transfer to reserves any additional amount of profit or carry forward any amount of profit, as they consider necessary, after statutory transfer of profits to reserves. Dividend can be paid only from the balance amount of profit.
10.6 COMPANIES ACT RELATING TO PAYMENT OF DIVIDEND
The provisions of the Companies Act relating to payment of dividend are as follows:
- Dividend shall only be payable in cash. But this will not prohibit capitalisation of profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any unpaid amount of shares held by the members of the company: Section 205(3).
- Dividend payable in cash may be paid by cheque or dividend warrant. This has to be sent by post directly to the registered address of the shareholders entitled to the payment of the dividend or in the case of joint holders to the registered address of that one of the joint shareholders which is first named in the register of members or to such person and to such address as the shareholder or the joint shareholders may in writing direct: Section 205(4)(b).
- The department of company affairs has clarified through its Circular No. 5/99 dated 12.5.1999 that dividend can also be transmitted electronically to the shareholders after obtaining their consent in this regard and asking them to nominate specific bank account number to which dividend due to them should be remitted.
- Dividend has to be paid to the registered holder of share or to his order or to his banker. In case a share warrant has been issued in respect of the share in pursuance of Section 114, dividend shall be paid to the bearer of such warrant or to his banker Section 206.
- Dividend has to be paid or the dividend warrant has to be posted within 30 days from the date of declaration of dividend, subject to certain exceptions: Section 205(4)(1).
- Where a dividend has been declared by a company but has not been paid or the warrant in respect thereof has not been posted within 30 days from the date of the declaration to any shareholder entitled to the payment of the dividend, every Director of the company shall, if he is knowingly a party to default, be punishable with simple imprisonment for a term which may extend to three years and shall also be liable to a fine of Rs. 1000 for every default during which such default continues: Section 207.
But the above provision is not applicable in the following circumstances:
- Where the dividend could not be paid by reason of the operation of any law
- Where a shareholder has given direction to the company regarding the payment of the dividend and those directions cannot be complied with
- Where there is a dispute regarding the right to receive the dividend
- Where the dividend has been lawfully adjusted by the company against any sum due to it from the shareholder
- Where, for any other reason, the failure to pay the dividend or to post the warrant within the period aforesaid was not due to any default on the part of the company
- Any dividend, when declared, the amount thereof shall have to be deposited in a separate bank account within five days of declaration. The amount of dividend deposited in a separate bank account as above shall be used for the payment of interim dividend. Section 205(1A).
10.7 COMPANIES ACT REGARDING UNPAID AND UNCLAIMED DIVIDEND
The provisions of the Companies Act regarding unpaid (unclaimed) dividend are as follows:
- Where, after the commencement of the Companies (Amendment) Act, 1974 a dividend has been declared by a company but has not been paid or claimed within 30 days from the date of the declaration, to any shareholder entitled to the payment of the dividend, the company shall, within seven days from the date of expiry of the said period of 30 days, transfer the total amount of dividend which remains unpaid or unclaimed to a special account to be opened by the company in that behalf in any scheduled bank to be called “unpaid dividend account”. Section 205A(1).
- If the default is made in transferring the total amount referred to in Sub section (1) or any part thereof to the unpaid dividend account of the concerned company, the company shall pay from the date of such default, interest at the rate of 12% per annum and the interest accruing on such amount shall be used for the benefit of the members of the company in proportion to the amount remaining unpaid to them. Section 205A(4).
- Any money transferred to the unpaid dividend account of a company in pursuance of this section, which remains unpaid or unclaimed for a period of seven years from the date of such transfer shall be transferred by the company to the fund known as Investors Education and Protection Fund established under Sub-section (1) of Section 205C. Section 205A(5).
- If a company fails to comply with any of the requirements of this section, the company and every officer of the company, who is in default, shall be punishable with fine which may extend to Rs. 5000 for every day during which the failure continues. [Section 205A(8)].
- Any person claiming to be entitled to any money transferred under Sub-section (5) of Section205A to the general revenue account of the central government may apply to the central government for an order for payment of the money claimed, and the central government may, if satisfied, whether on a certificate by the company or otherwise that such person is entitled to the whole or any part of the money claimed, make an order for the payment to that person of the sum due to him after taking such security from him as it may think fit. Section 205B.
10.8 PAYMENT OF DIVIDEND OUT OF CAPITAL PROFIT
Capital profits are those profits which arise from capital sources and not from normal trading activity of a business. Capital profits are not frequently earned in a business. These profits are earned from capital transactions and assets revaluation.
Following are the examples of capital profits:
- Profit prior to incorporation
- Premium received on the issue of shares or debentures
- Profit on forfeiture of shares and re-issue of forfeited shares
- Profit made on sale of fixed assets
- Profit on revaluation of fixed assets
- Profit on redemption of debentures at a discount
Section 205 of the Companies Act provides that dividend can only be paid out of profits. Profits can be both revenue profits and capital profits. So the Companies Act does not provide any general restriction on the distribution of capital profit as dividend. But the following capital profits are not available for distribution of dividend:
1. Premium on issue of shares
As per Section 78 of the Companies Act, premium on issue of shares is available only for certain specified purposes and not for payment of dividend.
2. Profit on re-issue of forfeited shares
As per Part I of Schedule VI of the Companies Act, the amount of profit made on forfeiture of shares has to be shown by adding to the called up share capital of the company in its balance sheet and the amount of such profit finally left after re-issue of forfeited shares has to be transferred to capital reserve.
A company comes into legal existence only from the date of incorporation. So, the profit earned during the period when the company was not in existence can not be legally distributed as profit of the company.
4. Profit from redemption of debentures at a discount
A capital profit earned from the redemption of debentures at a discount is not available for distribution as dividend as was held in the case Wall vs London and General Provincial Trust Co. Ltd. (1930).
10.9 PAYMENT OF DIVIDEND OUT OF CAPITAL
According to the Companies Act, no dividend can be paid out of capital as it expressly provides in Section 205 that the dividend is payable only out of current profit or past undistributed profits, arrived at after providing for depreciation. Therefore, if the memorandum or the articles of association even empower the company to declare dividend out of capital, such power becomes automatically invalid. [Verner vs General and Commercial Investment Trust Ltd. (1894)]
In the following circumstances, payment of dividend may amount to payment of dividend out of capital:
- If dividend is paid out of the sale proceeds of fixed assets
- If profits are inflated by the following
- Charging revenue expenditure to capital
- Making lower provisions for depreciation or liabilities
- Overvaluing closing stock or investments
- Excluding revenue expenditure from accounts
- Increasing profit by any other way
- If a deficiency of capital exists and dividend is paid without making good such deficiency.
Payment of dividend out of capital indicates returning to the shareholders part of the paid-up share capital as dividend. The payment of dividend out of capital has the following consequences:
- The Directors may have a right of indemnity against the members who knowingly received dividend out of capital. But they lose that right where the directors represent that the dividend was paid out of profits (Moxham vs. Grant-1990).
- In the absence of suspicious circumstances, the Directors are never wrong in accepting the reports and valuation of trusted officers of the company (Kingston Cotton Mills Co. – 1896).
- The Directors are personally liable to make good the amount, which they have knowingly paid as dividend out of capital (London and General Bank - 1895).
- When the payment of dividend out of capital is subsequently made good out of profit, the Directors can escape liability (Boaler vs The Watchmakers’ Alliance and others - 1903).
- An auditor cannot be held liable for negligence of duty for his inability to detect payment of dividend out of capital, if he has exercised reasonable skill and care and there is no suspicious circumstances for detection of deliberate enhancement of profit (Kingston Cotton Mills Co. Ltd. - 1896).
10.10 GENERAL GUIDELINES FOR DISTRIBUTION OF DIVIDEND
Following guidelines govern the distribution of profit as dividend by a company in general way :
- Dividend can be declared and paid only if the cash position of the company is satisfactory.
- Shareholders’ capital must not be utilised for the payment of dividend.
- A dividend should not be paid without making an adequate provision for depreciation on fixed assets.
- Capital profits may be distributed as dividend only if the following conditions are satisfied:
- The Articles of Association of the company permit such a payment
- Such capital profits have been realised
- The surplus remains even after the revaluation of all the other assets
- If there is a debit balance in the profit and loss account, dividend should not be distributed.
- If goodwill or other assets have been excessively written down in the past, the excess may be written back to profit and loss account and dividend can be distributed out of such profit.
- The company should adopt a steady dividend pay-out ratio. It need not distribute the whole of the profit amongst its shareholders as dividend.
- Provision of the Companies Act, Income-tax Act and the decisions of significant legal cases have to be observed and complied with while declaring dividend.
- Capital losses, intangible assets and ficticious assets should be written off over a period of time gradually to strengthen the financial position of the company.
- The provisions of the Memorandum and Articles of Association must be complied with before distributing profit as dividend.
10.11 ARTICLES OF ASSOCIATION REGARDING DIVIDEND
The provisions of the Articles of Association of a company should also be considered before distribution of profit as dividend along with the provisions of the Companies Act. But, it may be noted in this regard that no provisions as contained in the Articles of Association superceed the provisions of the Companies Act. If a company has no articles of its own, then it has to follow the privisions as contained in Table A as a substitute of articles of association.
Regulations 85 to 94 of Table A of the Companies Act describe the provisions regarding distribution of dividend by a company, which are given below:
- Clause 85 The company in general meeting may declare dividends, but no dividend shall exceed the amount recommended by the Board of Directors.
- Clause 86 The Board may from time to time pay to the members such interim dividends as appear to be justified by the profits of the company.
- Clause 88 Subject to the rights of persons, if any, entitled to shares with special rights as to dividends, all the dividends shall be declared and paid according to the amount 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 of the company, dividends may be declared and paid according to the amounts of the shares.
All dividends shall be apportioned and paid proportionately to the amount paid or credited on the shares.
- Clause 89 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 etc.
- Clause 91 Any dividend, interest or other money payable in cash may be paid by cheque or warrant sent through post directed to the registered address of the shareholders.
Every such cheque or warrant shall be made payable to the order of the persons to whom it is sent.
- Clause 92 Any one of two or more joint holders of shares may give effectual receipts for any dividends or bonuses payable in respect of such shares.
- Clause 93 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 94 No dividend shall bear interest against the company.
10.12 AUDITOR’S DUTY AS REGARDS PAYMENT OF DIVIDEND
Once dividend is declared, it constitutes an item of liability of the business. As specified above that Regulation of Clause 85 of Table A of 1st schedule states that no dividend shall be paid in excess of the amount of dividend declared. But this does not mean that the company should pay less than what is declared. Accordingly, a company may be sued by the shareholders for such payment as was held in the case Savern vs Wye Railway Co. (1896).
The duties of an auditor in connection with the payment of dividend are as follows:
- He should examine the documents of the company to ascertain the various rights and privileges of the various categories of the members.
- He should also examine the minutes of both director’s and shareholder’s meeting regarding such payments.
- He should verify the rate of dividend and justify the rate in the context of the amount of profit earned.
- He should see that the unclaimed dividends have been transferred to a separate bank account.
- He should obtain the register of members to justify whether dividend warrants have been sent to the appropriate persons.
- He should verify the articles of association to verify the authority for such payment.
- He should confirm that the declaration of dividend does not affect adversely the working capital position of the company.
- He should see that the provisions of the Companies Act relating to declaration and payment of dividend (Section 205) have been duly complied with before declaration and payment of dividend.
- He should ensure the basic principles of accounting and provisions regarding transfer of reserves have been duly adhered to while arriving at the distributable profit.
- He should also consider the rate of interim dividend declared by the company and confirm that it has been considered in the declaration and payment of the final dividend.
10.13 PAYMENT OF INTERIM DIVIDEND AND THE ROLE OF AUDITORS
Interim dividend is a dividend which is paid in respect of a year before the declaration of the final dividend. This means that it occurs between two annual general meetings and the declaration is done by the Directors instead of the shareholders.
Sub-section (1A) of Section 205 empowers the Board of Directors of a company to declare interim dividend. Clause 86 of Table A of Schedule 1 to the Companies Act provides that the board may from time to time pay to the members such interim dividend as appeared to be justified from the profits of the company. Generally, the Articles of Association of a company gives this power to the board of directors. Till the passing of the Companies (Amendment) Act, 2000, there was no provision in the Companies Act (except Regulation 86 of Table A) relating to interim dividend. The Companies (Amendment) Act, 2000 has introduced Sub-section (14A) in Section 2 whereby ‘interim dividend’ is now part of dividend and accordingly all provisions of the Companies Act relating to dividends have become applicable to interim dividend also.
To put things beyond doubt, Section 205 has also been amended to provide for the following:
- The Board of Directors may declare interim dividend and the amount of dividend including interim dividend shall be deposited in a separate bank account within five days from the date of declaration of such dividend.
- The amount of dividend including interim dividend so deposited above shall be used for the payment of dividend including interim dividend.
- The provisions contained in Sections 205, 205A, 205C, 206, 206A and 207, as far as may be, also apply to interim dividend.
Often an auditor’s advice is sought in the matter of payment of interim dividend. Following points are required to be considered by the auditor while giving advice to the management :
- Interim profit and loss account should be prepared, if posssible by a fair estimate of the closing stock.
- Where the closing stock value at the end of the interim period cannot be fairly ascertained, a rough estimate of profit can be made by applying the gross profit percentage to sales and deducting from such gross profit the expenses to date.
- All adjustments on account of bad and doubtful debts, depreciation, outstanding liability, prepaid expenses etc. should be duly made to ascertain the fair profit for the interim period.
- The proportion of interim profit to be applied to the payment of interim dividend should always be on the conservative approach after consideration of the forecasts for the future months and the allowances required for contingencies.
- A good cash balance should not be taken as an indicator of profit for the purpose of interim dividend. However, cash is also another decision factor.
- Future requirement of cash for expenses, asset replacement, loan repayment and working capital requirement should be fairly estimated. A good cash position does not always justify the payment of interim dividend, as the future cash requirement for those purposes may be quite substantial.
- It is the final dividend which has to be declared after the closing of the accounting year at a rate reasonably higher than the rate of interim dividend. Hence, it should be seen whether the company would be able to declare final dividend at a higher rate or not.
In paying interim dividend, the Directors undertake certain amount of risk, because an interim dividend is in fact a dividend in respect of the whole year and for the year if there is a loss, the payment of interim dividend will amount to payment of dividend out of capital, where there are inadequate balances of reserves and surplus.
10.14 LEGAL VIEWS AS REGARDS DIVIDEND
Case: Lee vs Neuchatel Co. Ltd. (1889)
Fact of the case: The Articles of Association of the company provided for the distribution of profit on preference shares and ordinary shares at the rate of 7% and 4% respectively. For that the consent of the shareholders is a must. Moreover, the Articles of Association of the company contained a clause which does not bind the directors to make reserve for replacement or renewal of any property. The Directors decided to declare dividend out of profits of the company to the preference shareholders without making good the loss of depreciation of wasting assets, i.e. mines and other assets of the company. One of the ordinary shareholders Mr. Charles John Lee brought an action against the Directors of the company restraining them to pay dividend without making good the depreciation of assets of the business.
Legal view: It was held that the company may distribute dividend without making good the depreciation on wasting assets, if it is authorised by its Articles of Association to do so. In fact, the object of charging depreciation is for the replacement of assets, but when the wasting assets are subject to exhaustion the company is formed to go into liquidation, the question of replacement does not arise.
Fact of the case: The business of the company consisted of buying, selling, letting, cultivating and otherwise dealing with land in South Africa. In the year 1892, the company, under peculiar circumstances debited to its profit and loss account £ 70,000 as bad debt and credited in the same profit and loss account with an equal amount arising from revaluation in the value of land, over and above the cost price. Accordingly, the profit and loss account was balanced. Subsequently, the company earned working profit and declared dividend from the said source in respect of the arrear dividend of 1885.
Legal view: An action was brought before the court against the company restraining it to capitalise a part of the reserve that has been created by revaluation of assets of the company. The basic reason behind such action was that the profits of the business are not realised. But it was held that surplus of capital assets resulting from bonafide revaluation of assets, even though it is unrealised, may be available for issuing bonus shares. The application of this decision cannot be made possible in India after the introduction of the Indian Companies Act, 1956.
Case: Foster vs The New Trinidad Asphelte Co. Ltd. (1901)
Fact of the case: The company along with the assets of the other company took over a debt of £ 1,00,000 secured by promissory note, at its formation. At that time, the debt was considered valueless. Later on, the debt was paid in full together with an interest accrued amounting to £ 26,258. 16s. The directors proposed to distribute the amount as dividend as the directors treated the said amount as capital profit. But one shareholder, brought an action before the court restraining the company to pay dividend on the ground that the decrease in the value of other assets should have been considered.
Legal view: It was held in this case that the question of what is profit available for dividend depends upon the results of the whole accounts taken fairly for the year, capital as well as profit and loss, and though dividends may be paid out of earned profits in proper cases, notwithstanding a depreciation of capital, a realised accretion to the estimated value of one item of capital asset cannot be deemed to profit divisible among the shareholders without reference to the result of the whole account fairly taken.
Case: Ammonia Soda Co. Ltd. vs Arthur Chamberlain and others (1918)
Fact of the case: An action was brought by the company against the former two Directors, asking them to refund to the company a sum amounting to £ 1268. 14s. 4d. which was illegally paid as dividend during the years from 1912 to 1915. The company was incorporated as a private limited company in July 1908. Thereafter by a special resolution, passed in October 1911, it was converted into a public limited company. The company’s profit and loss account showed a debit balance amounting to £ 19,028. 5s. 4d. The directors were entrusted to value the land, and accordingly it was valued at £ 79,166 and the addition of expenses for the innovation of new bed of rockself amounting to £ 20,542. 2s. 4d. was added to the value of land. The sum was credited to reserve account and was used to write-off the following:
- The debit balance of the profit and loss account amounting to £ 12,970. 18s. 3d.
- Goodwill for £ 1,500
- Cash bonus for £ 1,980
And the balance £ 4,091. 4s. 5d. was transferred to reserve account. During half year ended 31.01.1912, the company made net profit of £ 7,348. 13s. and the value of the land was increased in the balance sheet to the extent of £ 16,450. 18s. 3d. and thus eliminating the credit balance for £ 4091. 4s. 5d. which was left to the credit of the reserve account. During the years 1912 to 1915 dividends amounting to £ 1,268. 14s. 4d. were paid to the preference shareholders.
Legal view: The court decided that the assets of the business may be written up as a result of bonafide revaluation and that the current profits may be divided without making good past losses of the business. But the decision of this case in no way holds good in India after the introduction of Section 205(1)(b) of the Indian Companies Act, 1956.
Case: Stapley vs Red Brothers (1924)
Fact of the case: The company had written off the balance of goodwill account £ 51,000 out of reserve. In a later year, the profit having been found inadequate for both setting off the debit balance of the profit and loss account and paying dividend on preference shares including arrear dividend, the Directors decided to write up goodwill by £ 40,000, being the conservative value of goodwill and credit the sum to reserve account which could be utilised for writing off the debit balance £ 25,500 of the profit and loss account and paying the dividend. A shareholder, thereupon, moved the court for an injunction to restrain the directors from writing back £ 40,000 which was previously written off out of reserves created from profit.
Legal view: It was held that a company could write up at a fair value the goodwill, which was written off excessively in the earlier years and utilise the sum for writing off the debit balance of the profit and loss account and distribute the current profit as dividend.
POINTS TO PONDER
- The portion of profit, which can legally be distributed to the shareholders of the company by way of dividend, is called the divisible profit.
- According to ICAI Guidance Notes dividend is a distribution to shareholders out of profits or reserves available for this purpose.
- According to ICAI Guidance Notes profit is the excess of revenue over related costs. All the profits of a company cannot be said to be divisible. Only those portions of the profit, which can be legally distributed to the shareholders of the company in the form of dividend, are called divisible profit.
- The principal determinants of divisible profit are depreciation, grant by the government, arrear depreciation, past losses, transfer of profits to reserves, cash position of the company and taxation aspect.
- Dividend shall only be payable in cash. It can be paid by cheque or dividend warrant. It has to be paid to the registered holder of share or to his order or to his banker. Dividend has to be paid within 30 days from the date of declaration of dividend and the amount shall have to be deposited in a separate bank account within 5 days of declaration.
- If dividend is unpaid or unclaimed, the company shall, within 7 days from the date of expiry of the said period of 30 days, transfer the total amount of dividend to a special account called unpaid dividend account.
- Capital profits are those profits, which arise from capital sources and not from normal trading activity of a business. Companies Act does not provide any general restriction on the distribution of capital profit as dividend. But premium on issue off shares, profit on reissue of forfeited shares, profit prior to incorporation and profit from the redemption of debentures at a discount are not available for distribution of dividend.
- According to the Companies Act, no dividend can be paid out of capital. Payment of dividend out of capital indicates returning to the shareholders part of the paid-up share capital as dividend.
- The provisions of the Articles of Association of a company should also be considered before distribution of profit as dividend along with the provisions of the Companies Act. Regulations 85 to 94 of Table A of the Companies Act describe the provisions regarding distribution of dividend by a company.
- The auditor should see that the provisions of the Companies Act relating to declaration and payment of dividend have been duly complied with before declaration any payment of dividend.
- Interim dividend is a dividend, which is paid in respect of a year before the declaration of the final dividend. The Companies Act provides that the board from time to time pay to the members such interim dividend as appeared to be justified from the profits of the company.
- The auditor should consider the rate of interim dividend declared by the company and confirm that it has been considered in the declaration and payment of the final dividend. He should also ensure that the basic principles of accounting have been duly adhered to while arriving at the distributable profit.
- What is dividend?
- What is interim dividend? When does the question of interim dividend arise?
- State with reasons whether you, as an auditor, would approve the payment of dividend out of capital.
- Can dividend be paid out of current profits without writing off intangible and ficticious assets?
- Can dividend be paid out of profit arising out of forfeited and re-issue of shares?
- State the provisions of the Companies Act, 1956 regarding the declaration and payment of dividend.
- Can dividend be paid under the following circumstances:
- Out of current profit without making good past losses
- Out of a capital profit
- Out of past profit when there is neither profit nor loss in the current year
- Realised capital profits
- State the provisions of the Companies Act, 1956 regarding declaration and payment of Interim dividend. What would be the duty of an auditor in connection with such dividend?
- What do you understand by ‘divisible profit’? State what considerations should be borne in mind before declaring dividend.
- While examining the accounts of a company, you find the following items on credit side of profit and loss account:
- Profit on revaluation of land
- Bounties received from central government
- Excess depreciation charged in the previous year now written back
- Unclaimed dividend
Would you have any objection as auditor in passing the accounts of the company? State with reasons.