Audit of divisible Profits and Dividends (Part - 2) - Auditing & Secretarial Practice | Auditing and Secretarial Practice - B Com PDF Download

Q.11. Can a dividend be declared out of cur­rent profits without making good dep­reciation of fixed assets? Discuss with reference to the legal position in In­dia.

Ans. Section 205 of the Companies Act, 1956. 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. 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.

Q.12. While examining the Profit and Loss Account of a company, you find that the Directors propose to distribute the following items as dividends:

(A) Profit on revaluation of Freehold Premises;

(B) Profit on realisation of Debtors taken over; and

(C) Profit on sale of Bombay Branch Assets.

(D) Bounties received from the Cen­tral Govt.

Would you certify the ac­counts as correct?

Ans. (A) Profit realised on revaluation of Freehold Premises is a ‘Capital profit’. It is not available for distribution as a dividend unless:

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

(ii) Such asset is realised in cash, and

(iii) A surplus remains after a proper valuation of all assets of the company.

(B) Profit on realisation of Debtors taken over can be distributed to the shareholders provided that a reference is made to the book value of the whole of the assets and that the Articles of Association per­mit such distribution.

(C) Same as at (A) above.

(D) Bounties received from the Central Govern­ment is a revenue profit. It has been earned during normal business operations, and therefore, can be distributed as a dividend.

Q.13. (A) What do you understand by the expression ‘dividends’ are paid out of capital? (B) When will dividends be deemed to have been paid out of capital? (C) What are the conse­quences if dividends are paid out of capital?

Ans. (A) The expression means the payment of dividend out of the assets acquired with the paid-up capital of the company. Such payment amounts to a reduction of the share capital itself on a volun­tary basis as some part of the money forming the capital is returned to the shareholders. Dividend is a return on capital and not a return of capital itself. On this ground, the company law prohibits the pay­ment of dividend out of capital.

(B) Dividends will be deemed to have been paid out of capital, if:

(i) A revenue expenditure is booked to capital with an aim at inflating the profits of a com­pany.

(ii) A company distributes the sale proceeds of fixed assets.

(iii) A company pays dividend even in case of loss disclosed in the profit and loss account and even in absence of undistributed prof­its.

(C) If dividends are paid out of capital, the follow­ing consequences will result:

(i) The shareholders are to repay the amounts if they have received the dividend with full knowl­edge of the facts.

ii) The directors shall be jointly and severally liable to repay the amounts with interest. They will not be liable for dividends wrongly paid if it is proved that they acted honestly on the bonafide valuation by the company officials.

Q.14. Can a company declare dividends—

(a) Out of sale proceeds of its branch and goodwill in a foreign country.

(b) Out of the profits arising from the redemption of debentures at a dis­count?

Ans. (a) Profit on sale proceeds of a compa­ny’s branch and goodwill is a capital profit, and so, it is not available for dividend distribution unless:

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

(ii) The amount is realised in cash, and

(iii) A surplus remains after proper valuation of all assets.

(b) This is a capital profit. But such profit cannot be distributed as dividend in the light of a case law: Wall vs. London and General Provincial Trust Co. Ltd., (1920). Justice Younger decided the case by saying— “Where the Double Account system ex­ists, no transfer can be made from one account to another. An appreciation of capital never increases the income balance. To do this, single account must be adopted. This discount is not either net profit of the Company or net profit arising from its business and the directors are not entitled to distribute it as dividend”.

Q.15. A limited Company has made suffi­cient profits to enable it to declare a dividend, but due to a small existing bank balance the dividend cannot be paid. Your advice is sought as to how to raise the money for the purpose.

Ans. Before an advice is given for raising the necessary funds, it would be prudent to analyse the factors that have contributed to the insufficiency of bank balance.

The relevant factors may be:

1. (a) Overvaluation of stock-in-trade.

(b) Under-valuation of liabilities.

(c) Fictitious sales.

(d) Inadequate provision or no provision for (i) depreciation and/or (ii) bad and doubtful debts.

2. (a) Excessive stock-in-trade,

(b) Excessive book debts.

(c) Excessive capital purchases for expanding the business,

If the insufficiency of bank balance is due to the factors listed under (1) above, the payment of dividend does not arise in view of untrue profits.

If the insufficiency of bank balance is due to the factors listed under (2) above, dividend should be paid.

The company, in such circumstances, may adopt any or more of the following methods to raise the money:

(i) Overdraft arrangement with the Bank­ers.

(ii) Issue of debentures.

(iii) Issue of more shares provided that there is sufficient unissued capital.

Q.16. How would you, as an auditor, vouch— (a) Dividends, and (b) Un­claimed dividends? (b) (i) What is meant by ‘unclaimed dividend’? (ii) State how it should be treated in ac­counts. (iii) Explain in brief the duty of an auditor in relation thereto.

Ans. (a) Dividends:

(1) Examining the Arti­cles of Association to ascertain the class of shares having dividend rights, and the board’s resolutions declaring the rate of dividend.

(2) Verifying:

(i) The computations of gross and net dividends payable to each shareholders,

(ii) The schedules of gross and net dividends with the divi­dend warrants, income tax deduction list, and the dividend account; and (iii) the amount transferred to the Dividend account from the Bank Account.

(3) Checking the dividend account’s Pass Book with the Dividend Warrants returned to ascertain the unclaimed dividends, and also the Directors’ Minute Book to find out whether unclaimed divi­dends have been forfeited.

(4) Ensuring that:

(i) The dividends on prefer­ence shares are paid after deduction of income tax;

(ii) The provisions of Section 205 of the Compa­nies Act regarding the depreciation provision, trans­fer to reserve, writing off of the past losses, etc., have been complied with; and

(iii) The Articles of Association authorize the payment of dividend, in case of bonus shares, in the form of ‘scrip’.

(b) Unclaimed Dividends:

When certain shareholders do not claim the divi­dends declared by the company, the amounts of dividends so unpaid are Unclaimed Dividends.

Vouching of this item extends to:

(1) Whether the dividends remaining unpaid for forty-two days have been transferred, within seven days after expiry of this period, to a separate bank account under ‘Unpaid Dividend Account of… Co. Ltd.’

(2) Whether the amounts are shown as liabili­ties in the balance sheet.

(3) Whether the amounts remaining unpaid or unclaimed after the expiry of three years from the date of such transfer have been passed on to the ‘Consumer Welfare Fund’ of the Central Govt., as per the provisions laid down under Section 205 B of the Companies Act, 1956 and as per the Con­sumer Welfare Fund Rules of 1992.

(4) Whether the company had paid the interest due on the amount of unclaimed dividend in case of its failure to transfer the amount to a separate bank account as required by law.

Q.17. Discuss the commercial view-points regarding distribution of ‘Capital Profits’.

Ans. The follow­ing essential points should be borne in mind before a decision is taken to distribute capital profits:

(1) Whether the working capital is sufficient to meet the commitments of the business.

(2) Whether the plans are afoot for expansion of the business for which extraneous gains through capital profits would provide additional capital.

(3) Whether there is any capital loss to the com­pany.

(4) Whether there is a necessity to reduce or wipe off intangible assets, such as — preliminary expenses, underwriting commission, etc., for which such profits can be utilised.

Q.18. State the principles (i.e., decisions) laid down in the following case laws with regard to the distribution of prof­its as dividend:

(a) Foster vs. New Trinidad Asphalte Co. Ltd.;

(b) Lubbock Vs. British Bank of South America;

(c) Spanish prospecting Co. Ltd.;

(d) Lee vs. Neuchatel Asphalte Co. Ltd.;

(e) Ammonia Soda Co. Ltd. vs. Arther Chamberlin;

(f) Wilmer vs. Mc. Namara & Co. Ltd.;

(g) Bolton vs. Natal Land & Colonisation Co. Ltd.;

(h) Crabtree Thomas vs. Crabtree;

(i) Staply vs. Read Bros. Ltd.

Ans. (a) A realised accretion to the estimated value of one item of capital assets cannot be deemed to be profit divisible amongst the shareholders with­out reference to the result of the whole accounts fairly taken for that year, capital as well as profit and loss.

(b) The profit, which is on capital and not a part of the capital itself, should be available for distribution as dividend if the Articles of Associa­tion of a company so provide.

(c) The term ‘Profit’ implies comparison bet­ween the states of a business at two specific dates, usually separated by an interval of a year. This can only be ascertained by a comparison of the assets of the business of the two dates. Thus, the terms ‘profits’ and ‘profits legally distributable to the shareholders’ should be clearly distinguished.

(d) If a company is formed to acquire or work property of wasting nature, e.g., a mine, quarry or patent, the capital spent in acquiring the property may be regarded as sunk and gone. If a company retains assets sufficient to pay its debts, the excess of money obtained by working the property over the cost of working may be distributed among the shareholders even without making depreciation provisions on the wasting assets provided the Arti­cles of Association do not compel it to do so.

The above principle does not hold good in In­dia in view of the provisions in the Companies Act, 1956 which enjoins that depreciation must be pro­vided on assets before the distribution of profits to the shareholders.

(e) A company may write up the assets of its business as a result of bonafide revaluation and may distribute current profits without making good prior losses. Further, a company in absence of any rule of law may set-off an appreciation in value of its capital assets following a bonafide revaluation against the losses of current revenue accounts and the payment of dividend in this case is deemed to be paid out of current profits. This decision does not hold good in India. Any loss suffered in the previous year(s) must be set-off against the current year’s profits in terms of Sec­tion 205 of the Companies Act, 1956.

(f) A company may declare dividends out of current profits even without making depreciation provisions on its fixed assets. However, this deci­sion is inapplicable in India in view of Section 205 of the Companies Act, 1956.

[Facts of the case (This does not form an an­swer here). The company was carrying on a busi­ness of movement of mails, parcels, etc. It was pro­viding depreciation on its assets in the past. But in one year, it declared dividends to the preference shareholders without any depreciation provisions. Mr. Wilmer and ordinary shareholders brought an action against the company in the court. The Judge observed that ‘the Balance Sheet cannot be im­peached simply because it does not charge anything against revenue in respect of goodwill.]

(g) A company may declare dividends out of current profits without making good previous loss of capital assets. However this decision is not ap­plicable in India according to Section 205 of the Companies Act, 1956.

(h) Depreciation on plant and machinery must be provided before arriving at the profits if a manu­facturing business is to continue for an indefinite period.

(i) A company can pay dividends out of cur­rent profits by writing up the assets again to the extent it has written down its assets excessively in the past.

Q.19. Is it permissible for a company after having written down in the past, some of its assets excessively out of profits, to assets excessively out of profits, to write them up again on a subsequent occasion and credit the excess to Profit and Loss Account for the purpose of dividend ? Discuss.

Ans. This question was raised by one of the shareholders of the company before the Court in the case of Staply Vs. Read Brothers Ltd., (1924).

The arguments put forth by the company were:

(i) That the goodwill had been written off in the past at a very excessive rate;

(ii) That the debit balance in the Profit and Loss Account was the result of goodwill having been excessively written off in the past; and

(iii) That the present value of goodwill was more than what was proposed to be written up.

The court upheld the procedure adopted by the company by stating that, if the goodwill were re­tained as an asset in the balance sheet and if the profits were carried to a ‘goodwill depreciation re­serve fund’ instead of being used to write off the volume of goodwill, the company could distribute those profits at any time to the extent by which the amount of reserve fund exceeded the actual depre­ciation amount.

Thus, the surplus created as a result of the write- up of assets which was written down excessively in the past and credited to the Profit and Loss Ac­count represents the amount withheld from being distributed and is, therefore, available for the pay­ment of dividend to the shareholders.