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Dividends and Divisible Profits of a Company Auditing

Some of the most frequently asked exam questions on auditing for dividends and divisible profits are as follows: 

Q.1. Define and explain the term ‘Di­visible Profits’.

Ans. These refer to that portion of profits (i.e., the excess of income over expenditure including pro­vision for taxes and depreciation) which are avail­able for distribution as dividend to the sharehold­ers of the company. But this does not mean that any profit will be distributed if available.

The avail­able profit should be such that is legally distribut­able in accordance with the provisions contained in:

(i) The Companies Act, 1956,

(ii) The Income Tax Act, 1961, and

(iii) The Articles of Association of the Company.

In this context, a relevant question arises as to whether capital profits (which are not earned during the normal business operations but arise on the revaluation or sale of assets or on the re-issue of forfeited shares, etc.) are to be consi­dered as available for distribution as dividends. Un­der normal circumstances, these profits should not be distributed.

But these are distributable only on the conditions that:

(a) Such distribution is author­ised by the Articles of Association,

(b) Such sur­plus is actually realised in cash or remains after a proper valuation of all assets, and

(c) The capital losses are made good.

To quote from the well-known case law [Bueons Airs Great Southern Railway Co. vs. Preston (1947)], the divisible 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 profit for the year can be carried forward.”

Q.2. Explain the term ‘Di­visible Profits’ with reference to:

(1) Section 205 of the Companies Act, 1956,

(2) Income Tax Act, and

(3) The decided cases.

Ans. (1) Section 205 of the Companies Act 1956.

The term ‘divisible profits’ has not been defined in this legislation. The above section provides for certain conditions that must be fulfilled before the profits are distributed as dividends.

The important provi­sions are:

1. No dividend should be declared or paid by a company for any financial year except:

 (i) Out of the profits of the company for that year arrived at after providing for depreciation as per Section 205 (2) , or

(ii) Out of the profits of the company for any previous ‘financial year or years arrived at after providing for depreciation as per Section 205(2) and remaining undistributed, or

(iii) Out of both, or

(iv) Out of moneys provided by the Central Gov­ernment for the payment of dividends in pursuance of a guarantee given by that government.

2. If the company has not provided for depre­ciation for any previous financial year or years, it should provide for such depreciation out of the prof­its for that year or years before declaring or paying dividend.

3. If the company has incurred any loss in any financial year or years, then the amount of the loss or an amount equal to the amount provided for dep­reciation for the year or years whichever is less should be set-off against the profits of the com­pany for the year for which dividend is proposed to be declared or paid, or against the profits of the company for any previous financial year or years, arrived at in both cases after providing for depre­ciation as per Section 205 (2) or against both.

4. The Central Government may, in the interest of the public, allow any company to declare or pay dividend for any financial year without providing for depreciation.

The provisions 2 to 4 are necessarily to be fol­lowed as per the Companies (Amendment) Act, 1960. The Companies (Amendment) Act, 1974 also enjoins a provision that a company should provide reserve not exceeding 10% of its profits before the dividends are declared.

(2) Income Tax Act.

Section 109 of this Act pro­vides for declaration of a statutory percentage of distributable income as under in respect of the fol­lowing classes of companies:

45% in the case of a consultancy service company.

90% in the case of an investment company.

60% in the case of other companies.

It also states that the company must have to pay additional income tax if such statutory distribution is not made.

(3) Legal Decisions:

It is interesting to note that the decided legal cases in India and abroad pro­vide ample guidance for determining the quantum of divisible profits in addition to the provisions of Section 205 of the Companies Act which contain the detailed scheme of working out the amount of ‘divisible profits’. The management of the com­pany and the auditors should consider these legal decisions as sources of guidance to arrive at the divisible profits while recommending or comput­ing dividend.

In this context, we may cite briefly the following case laws:

1. Lubbock, vs. British Bank of South America Ltd. (1892):

The directors of the company treated the profit arising from the sale of a business as a profit avail­able for distribution as dividend. A shareholder ob­jected to this on the ground that this profit was a capital profit as it was realised on the sale of a part of the business. The court observed that the profits was on capital and, therefore, not a part of the capi­tal itself, and held that it should be available for dividend if the Articles of Association so provide.

2. Foster, vs. The New Trinidad Asphalte Co. Ltd., (1901):

The Company took over the assets of another company along with promissory notes which were regarded as of ‘no value’ at the time of take over. But at a later date the company realised the full debt with interest and credited the profit and loss account with the amount. The company directors also proposed to distribute the same as dividend. But a shareholder went to the court on the ground that these notes were not initially recorded in the books and the realisation on them was totally un­expected. The court also regarded this profit on re­alisation as capital profit.

Justice Byrne observed “….The amount of debt is distinct item of the prop­erty purchased which has since been realised by the payment……… The amount is prima facie capital. …. It is clear that an appreciation in the total value of the capital assets, if duly realised by sale of some portion of such assets, may in a proper case be treated as available for purposes of dividend. Ac­cretions to capital may be realised and turned into money which may be divided among the sharehol­ders. The question of what profit is available for dividend depends upon the result of the whole ac­counts fairly taken for that year, capital as well as profit and loss, and although dividend may be paid out of earned profits in proper cases, and although there has been a depreciation of capital, I do not think that a realised accretion to the estimated value of one item of capital assets can be deemed to be profit divisible amongst the shareholders without reference to the result of the whole accounts fairly taken.”.

3. Drown vs. Gaumont-British Picture Corps. Ltd., (1937):

It was held that the receipts of premiums on the issue of shares could be distributed as dividend provided that the Articles of Association of the company allow such action. But in India, this deci­sion does not hold good as the company has to trans­fer such premiums to the Share Premium Account in accordance with the company law.

4. Verner vs. General and Commercial Invest­ment Trust Ltd., (1894):

The main question before the court was “whether a limited company which has lost a part of its capital can lawfully declare or pay a dividend without first making good the capital which has been lost”.

It was held that:

(i) There was nothing in the Memorandum and the Articles of the company ne­cessitating the lost capital to be made good before the declaration of dividend;

(ii) There was no pay­ment of dividend out of capital; and

(iii) There was no insolvency.

The case, thus, concludes that a com­pany can distribute dividends out of the current year’s profit even without making good the part of lost capital if the Articles of Association permit. However this legal decision is inapplicable in In­dia in view of Section 205 of the Companies Act, 1956.

Q.3. The Directors of a public limited com­pany desire to distribute dividend out of profits realised as stated below. Comment on the legality of such dis­tribution.

(a) Share premium;

(b) Sale of company’s fixed assets;

(c) Capital Redemption Reserve;

(d) Forfeiture and Re-issue of shares;

(e) Develop­ment Rebate Reserve;

(f) Fixed Assets Revaluation Reserve;

(g) Tax Exempt Profits Reserve; and

(h) Sales Promo­tion Reserve.

Ans. (a) In accordance with the company law, a company has to transfer share premiums to Share Premium Account. The receipts of premiums, thus, cannot be distributed as dividend.

(b) Profit on the sale of company’s assets is not earned during normal business operations.

Hence, it is capital profit. This is available for distribution as dividend subject to the conditions that:

(i) Such distribution is authorised by the Articles of Asso­ciation, and

(ii) Such surplus in actually realised in cash. This profit is on capital and not a part of capi­tal, as decided in Lubbock, vs. British Bank of South America (1892).

(c) Capital Redemption Reserve:

This represents an amount transferred from profits available for divi­dend, equal to the nominal amount of any redeem­able preference shares otherwise than out of the proceeds of a fresh issue of shares. Under Section 80 of the Companies Act, it can only be applied in paying up unissued shares of the company to be issued to the members as fully paid bonus shares.

This Section further stipulates that a reduction of this reserve can be made only in the manner in which the share capital of a company can be re­duced. Thus, under the company law, this reserve is not available for distribution as dividend.

(d) Forfeiture and Re-Issue of Shares:

Where for­feited shares are re-issued, the amount realised in excess of the nominal value of the shares is trans­ferred to the Capital Reserve, and the premiums received on the original issue of shares remain in the Share Premium Account. Under regulations 29 to 35 of Table A of the Companies Act, 1956 the amount received on the forfeited shares is credited to the Forfeited Shares Account and shown in the Balance Sheet under: Share Capital.

This amount on credit can be applied to write off:

(i) Discount on the re-issue of shares, or

(ii) Fictitious assets like preliminary expenses.

Thus, this amount is not dis­tributable as dividend.

(e) Development Rebate Reserve:

This Reserve is created by a corresponding debit to the Profit and Loss Account of the relevant previous year with a view to utilizing the same for the purposes of a com­pany’s business for a specified number of years (usually ten years as per the present provisions in the company law). This reserve, thus, cannot be utilised for payment of dividend for at least eight years.

(f) Fixed Assets Revaluation Reserve:

This Re­serve is created by writing-up the fixed assets of a company as a result of revaluation. According to the present company legislation, the unrealized appreciation in the values of fixed assets is not available for dividend distribution.

(g) Tax Exempt Profits Reserve:

This represents those profits of an industrial company which are exempt from tax under section 84 of the Income Tax Act 1961. This is a Revenue Reserve and not a Capital Reserve. It can, therefore, be distributed as dividend.

(h) Sales Promotion Reserve:

It is an amount set aside for sales promotion purposes of a company, and therefore, a revenue reserve. The whole or a part of the amount, if unutilized, can be distributed as dividend.

Q.4. Can dividends be declared without taking into account past losses? Cite a decided case law.

Or, Can a company declare dividends out of current year’s profits without writing off previous year’s accumu­lated losses?

Ans. According to Schedule VI of the Com­panies Act, 1956, any debit balance in the Profit and Loss Account is to be set off against the rev­enue reserves of a company. This means that the loss of any financial year must be made good out of past undistributed profits. In the absence of past undistributed profits held in the form of revenue reserve, the question arises whether losses brought forward from previous years should be covered before any dividend can be declared from the cur­rent year’s profits.

The answer is that there is no legal obligation for a company to make good a debit balance on its Profit and Loss Account resulting, from the past losses before distributing current prof­its, but so much of the loss sustained by a company in one or more financial years, as is attributable to the amount of provision made for depreciation, must be set off against the current profits of a company before a dividend can be declared.

In a case law: Ammonia Soda Co. Ltd. vs. Chamberlin, it was held that it was not in all cases necessary to make good a debit balance in the Profit and Loss Account before distributing dividend out of current profits. Such payment of dividend is not necessarily a payment of capital. However, circum­stances leading to debit balance in P & L A/c must be studied.

Q.5. A Company cannot pay dividend out of capital. Why is this?

Ans. The payment of dividend out of capital means the payments of dividend out of the assets acquired with the paid-up capital of the company. Section 205 of the Companies Act, 1956 expressly provides that no dividend may be paid except out of the profits of the company or out the funds pro­vided for the purpose by the Central or State Gov­ernments. A dividend is a share of the profits of a company.

The company law prohibits the payments of dividend out of capital for the following reasons:

1. The share capital as mentioned in the Memo­randum of Association of a company is a fund meant for payment to the creditors in the event of the com­pany being wound up. This means that the capital is liable to be spent in carrying on the business of a company and not for giving it back to the members or shareholders.

2. The payment of dividend out of capital amounts to a reduction of share capital on a volun­tary basis without the leave of the court and with­out any sanction under any law in force including the company law.

3. The payment of dividend out of capital af­fects the value of the assets of a company, thereby having a serious effect on the securities offered against the secured loans. Thus, the liquidity posi­tion of a company is affected.

Q.6. State the various methods of depre­ciation that a company may adopt to comply with the provisions of Section 205 of the Companies Act, 1956 (the charge of depreciation before declar­ing a dividend).

Ans. For the purpose of ascertaining the quan­tum of divisible profits, the following approved methods of depreciation may be adopted by a com­pany to comply with the provisions of Section 205 of the Companies Act, 1956:

1. In the case of assets for which depreciation is allowable under the Income Tax Act, deprecia­tion may be provided for by any of the following methods:

(a) The written-down value method as adopted for income tax purposes. Normal depre­ciation including any extra shift allowance is to be provided for.

(b) The straight-line method by which 95% of the cost of an asset is equally written off each year during a specified period. [The expression ‘specified period’ means the number of years dur­ing which at least 95% of the cost of an asset would be provided for by way of depreciation if depre­ciation were calculated according to the written- down value method.]

(c) Any other method approved by the Cen­tral Government, which has the effect of writing off by way of depreciation at least 95% of the cost of an asset during the specified period.

Where any of the three methods is adopted, if an asset is sold, discarded, demolished or destroyed for any reason before depreciation of such asset has been provided for in full, the excess of its written-down value over its sales proceeds or its scrap value must be written off in the financial year in which it is sold, discarded, demolished or destroyed.

2. As regards any other depreciable assets for which depreciation is not allowable under the In­come Tax Act, depreciation must be provided for by such method as may be approved by the Central Government by any general or special order.  

Q.7. What do you understand by ‘In­terim dividend’? How does it differ from ‘Final dividend’?

Ans. It means a divi­dend paid to the members of a company in antici­pation of the profits of a year before the accounts of the company for that year have been prepared, audited and adopted at the annual general meeting. It is declared and paid on account of the full year’s dividend at any time between two annual general meetings.

Where no ‘interim dividend’ has been paid in any year, any further distribution to the shareholders on account of that year sanctioned at an annual general meeting on the recommendations of the directors is known as ‘final dividend’.

Q.8. Indicate the points that the direc­tors of a company should necessarily consider while deciding on the ‘In­terim dividend’.

Ans. The Articles of Association of a company authorize its directors to declare an interim dividend. Thus, considerable responsibility rests with the di­rectors.

The following points should, therefore, be looked into by the directors in this regard:

1. Preparation of interim accounts to ascertain the adequacy of profits.

2. Proper valuation of the assets and liabili­ties.

3. Inquiry into the conditions of trade and pros­pects for the rest of the year in order to anticipate any losses and contingencies.

4. Cash flow position and the position of fi­nancial commitments in the near future.

5. The past dividend policy, i.e., the rate and amount of dividend declared in earlier years.

6. The policy of conservatism to ensure that the dividend is not declared out of capital and that the rate of interim ‘dividend fixed is lower than the estimated rate for the whole year, because it is bet­ter to declare a higher final dividend than the in­terim.

Q.9. What considerations should be borne in mind before declaring dividends? Or, Discuss the legal view-points re­garding distribution of ‘Capital Pro­fits’.

Ans. The following considerations are neces­sarily to be borne in mind before declaring divi­dends:

1. Past Losses:

If the company has incurred any loss in any financial year or years, then the amount of the loss or an amount equal to the amount pro­vided for depreciation for the year or years which­ever is less should be set-off against the profits of the company for the year for which dividend is pro­posed to be declared or paid, or against the profits of the company for any previous financial year or years, arrived at in both cases after providing for depreciation as per Section 205 (2) or against both.

2. Depreciation:

If the company has not provided for depreciation for any previous financial year or years, it should provide for such depreciation out of the profits for that year or years before declar­ing or paying dividend. The Central Government may, in the interest of the public, allow any company to declare or pay dividend for any financial year without providing for depreciation.

The provisions are necessarily to be followed as per the Companies (Amendment) Act, 1960. The Companies (Amendment) Act, 1974 also enjoins a provision that a company should provide reserve not exceeding 10% of its profits before the divi­dends are declared.

3. Capital Profits:

Dividends can be paid only out of profits—capital profits or revenue profits.

Capital profits are available for distribution as divi­dend subject to the conditions that:

(i) Such dis­tribution is authorised by the Articles of Associa­tion,

(ii) Such surplus is actually realised in cash,

(iii) Such surplus remains after a proper valuation of all assets,

(iv) Such profits are not profits prior to incorporation of the company, and

(v) Such prof­its are not profits realised on redeeming compa­ny’s own debentures by purchase in the market at a discount.

4. Reserves:

(i) Profits appropriated to reserves or carried forward to next year are not available for dividend; and

(ii) An amount equal to 75% of the development rebate allowable for income tax assessment must be set aside from profits to deter­mine the amount of divisible profits which can­not be used for 8 years next for dividend for cur­rent year.

Q.10. (A) What do you understand by
 (i) Capital profits and
 (ii) Profits prior to incorporation?
 (B) Are such prof­its available for distribution as divi­dends? Discuss them.
 (C) State the purposes for which ‘profits prior to incorporation’ can be utilised.

Ans. (A) (i) Capital profits:

These refer to those profits which are not earned during the nor­mal business operations. That means, these result from other sources and are not traceable as trading profits.

The examples of capital profits are:

(a) Premium received on the issue of shares or debentures.

(b) Profit earned on the sale of fixed assets.

(c) Profit earned on the redemption of deben­tures by purchase at a discount.

(d) Profit earned on the resale of the forfeited shares.

(e) Profit earned prior to incorporation of a company.

(ii) Profits prior to incorporation:

These refer to the profits that might have been earned by a com­pany during a period commencing from the date of taking over a running business to the actual date of incorporation of that company.

(B) Section 205 of the Companies Act states that a dividend should be paid out of profits without mak­ing any discrimination as to revenue profits or capi­tal profits.

Capital profits are available for distribution as dividend subject to the conditions that:

(i) Such distribution is authorised by the Articles of Asso­ciation,

(ii) Such surplus is actually realised in cash,

(iii) Such surplus remains after a proper valuation of all assets,

(iv) Such profits are not profits prior to incorporation of the company, and

(v) Such profits are not profits realised on redeeming company’s own debentures by purchase in the market at a dis­count.

The case laws, viz. Lubbock vs. British Bank of South America and Foster vs. New Trinidad Lake Asphalte Co. Ltd. cor­roborate the view that capital profits are available for distribution as dividends.

Profits prior to incorporation of a company are not available for distribution as dividends on the following grounds:

(a) The company had not actually come into ex­istence before incorporation.

(b) The company cannot be assumed to have made profits before it comes into existence.

(c) The profits earned do not relate to the post- incorporation period.

(d) The shareholders do not have any right to share profits which relate to pre-incorporation period.

(e) The profits are of capital nature.

(C) The ‘profits prior to incorporation’ of a Com­pany can be utilised for the following purposes:

1. To pay off the interest on the purchase con­sideration to the vendors (who are entitled to this from the date the business is taken over to the date when such purchase consideration is discharged).

2. To write off Goodwill.

3. To write down other fixed assets.

4. To carry forward as a capital reserve.

The document Audit of divisible Profits and Dividends (Part -1) - Auditing & Secretarial Practice | Auditing and Secretarial Practice - B Com is a part of the B Com Course Auditing and Secretarial Practice.
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FAQs on Audit of divisible Profits and Dividends (Part -1) - Auditing & Secretarial Practice - Auditing and Secretarial Practice - B Com

1. What is the purpose of an audit of divisible profits and dividends?
Ans. The purpose of an audit of divisible profits and dividends is to ensure that the company's financial statements accurately reflect the amount of profits available for distribution as dividends. The audit helps to verify the accuracy and completeness of the company's calculations and disclosures related to divisible profits and dividends.
2. What are divisible profits?
Ans. Divisible profits are the profits of a company that are available for distribution among its shareholders as dividends. These profits are determined after taking into account various legal and financial considerations, such as statutory reserves, tax provisions, and retained earnings. Divisible profits represent the portion of the company's profits that can be distributed as dividends to shareholders.
3. How are divisible profits calculated?
Ans. Divisible profits are calculated by starting with the company's net profit for the financial year and making adjustments for various factors such as statutory reserves, tax provisions, and retained earnings. The specific calculation method may vary depending on the applicable laws and regulations, as well as the company's own policies and practices. It is important to accurately calculate divisible profits to ensure that the correct amount is distributed as dividends.
4. What is the role of an auditor in auditing divisible profits and dividends?
Ans. The role of an auditor in auditing divisible profits and dividends is to examine the company's financial statements, accounting records, and supporting documentation to determine the accuracy and completeness of the calculations and disclosures related to divisible profits and dividends. The auditor reviews the company's policies and procedures, tests the calculations, and ensures compliance with applicable laws and regulations. The auditor's opinion provides assurance to shareholders and other stakeholders regarding the reliability of the company's divisible profits and dividends.
5. What are the potential risks or challenges in auditing divisible profits and dividends?
Ans. Auditing divisible profits and dividends can involve various risks and challenges. Some potential risks include the misinterpretation of applicable laws and regulations, errors in financial calculations, inadequate documentation, and fraudulent activities. The auditor may also face challenges in obtaining sufficient and appropriate audit evidence, particularly in cases where the company has complex financial transactions or operations. It is important for the auditor to address these risks and challenges effectively to ensure the accuracy and reliability of the audit findings.
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