Include Audit related to Divisible Profits, Dividends | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• Different authorities have provided varying definitions of the term 'profit'. Economists ascertain profits by comparing the market values of net assets at two accounting dates. They consider the increase or decrease in net worth as the profit or loss for the intervening period. Accountants, however, have a different perspective. They view profit as the difference between revenue and expenses for an accounting period, assuming the business will continue as a going concern. They do not base profit on the realizable value of assets, and it can be challenging to objectively measure the market price of fixed assets.
• In the case of Spanish Prospecting Co. Ltd. (1911), it was noted that the strict meaning of 'profit' is rarely observed in drawing up accounts, and certain assumptions have become customary. For example, gains and losses not directly connected with the business are often excluded, and the value of trade buildings and plants is typically fixed arbitrarily, assuming a certain annual depreciation percentage. There is a wide variation in practice when estimating profits, but this variation is limited when third-party rights are involved.
• Accounting policies also play a significant role in determining true profits. Different policies, such as the straight-line method or written-down value method for depreciation, can lead to different profit figures. The valuation of inventories, whether at cost or net realizable value, can also vary depending on the method used. Additionally, the provision for bad debts and doubtful debts is subjective and depends on management's judgment.
• It is crucial that profits are determined according to generally accepted accounting principles and legal norms. Overstating profits can lead to the payment of dividends out of capital, reducing capital and potentially being considered ultravires and void. Understating profits can affect stakeholders' interests and lead to the creation of secret reserves, which is prohibited under the Act.

Divisible Profits and Dividends

• It's important to note that the term "divisible profits" isn't explicitly defined in the Act. Firstly, we need to accurately determine profits using generally accepted accounting principles. Secondly, it's not mandatory to distribute all profits among enterprise owners; a portion should be retained for growth and diversification. In the case of companies, the Act imposes restrictions on the extent of profit distribution among members. The portion of a company's profits legally distributable to members is termed 'divisible profits,' and the portion of divisible profits actually distributed is termed 'dividend.'
• Accounting principles, the Companies Act of 1956, and judicial decisions guide the determination of divisible profits. These factors include provisions outlined in the Companies Act, 1956, such as Section 205, which delineates the sources from which dividends can be paid. It mandates companies to provide for depreciation before declaring dividends and may require them to transfer some profits to reserves if dividends exceed certain limits.
• The Act also specifies that dividends can only be paid from the company's profits of the current year. Certain rules, such as Regulations 85-94 of Table A, govern the declaration and payment of dividends, including rules related to the transfer of profits to reserves. These rules also stipulate that dividends must be paid in cash and within 42 days of declaration.
• Legal cases, such as Lee v. Neuchatel Asphalte Co. Ltd. (1889), Verner v. General and Commercial Investments Trust Ltd. (1894), and Wilmer v. McNamara & Co. Ltd. (1895), provide precedents for dividend payments. These cases demonstrate that a company can pay dividends if it is solvent and acting within its Articles, even if its capital is not intact.

Distribution of Capital Profits

Profits accrued during regular business operations can be distributed as dividends under Section 205 of the Act. However, certain profits do not arise from regular business activities and fall under the category of capital profits. Capital profits arise from the sale of fixed assets, long-term investments, or their revaluation. The question arises whether such profits can be distributed as dividends.

The Act does not specifically address this issue. However, the decisions in the following two prominent cases may help in formulating general conclusions:

• Lubbock v. the British Bank of South America Ltd (1891): In January 1891, the British Bank of South America sold its branches in Brazil and repurchased them later at a profit of $2,05,000. The directors intended to credit the Profit and Loss Account with this sum and pay dividends to the shareholders. A shareholder initiated friendly legal action to test the legality of this action. The Court opined in favor of the directors, stating that dividends can be paid out of realized capital profits provided that the Articles of the company permit it, and a surplus is left after deducting the paid-up capital and liabilities from the sale proceeds, representing profit.
• Foster v. The New Trinidad Lake Asphalt Co. Ltd. (1901): The company was formed to acquire the assets of another business, including promissory notes initially estimated as valueless. After a few years, the company realized these promissory notes in full and credited the amount to the Profit and Loss Account. The company proposed to use these profits for dividend payments. A shareholder sought to restrain the company from using these profits as capital profits, arguing that they had arisen from the realization of previously valueless Promissory Notes taken over by the company at its formation.
• The Court held that these capital profits cannot be distributed as dividends without considering the overall results of the company's accounts. This would require the revaluation of all assets and liabilities of the company. Judge Byrne, in his judgment, observed that the profits available for dividends depend on the overall result of the whole account, including capital and profit and loss, and that the distribution of dividends should be based on earned profits.

Based on these court decisions, it can be concluded that capital profits may be distributed as dividends under the following conditions:

• The Articles of Association must permit the distribution of capital profits as dividends.
• The profit sought to be distributed must have been realized. Unrealized capital profits, such as those resulting from the revaluation of fixed assets, cannot be distributed as dividends. However, if the revalued assets are later sold, the amount realized above the original cost of these assets can be considered a capital profit available for distribution as dividends.
• The capital profit must remain after a fair valuation of all assets and liabilities. In other words, any decrease in the value of other assets or an increase in liabilities should be deducted from the capital profits to determine the amount available for distribution as dividends.
• It should be noted that capital receipts such as premium on shares and profits from reissue of forfeited shares cannot be distributed as dividends.

Auditor's Responsibilities Regarding Dividends

It is the auditor's duty to ensure that the company's dividend declaration and payment processes comply with the relevant provisions of the Companies Act, 1956. The audit procedures involve:

• Reviewing the Memorandum and Articles of Association to determine the dividend rights of various share classes.
• Verifying the dividend rate and authorization from the Shareholders' Minute Book.
• Ensuring compliance with procedural requirements for dividend declaration by reviewing board and general meeting minutes.
• Checking if dividends were paid within the prescribed time limit by examining dividend registers.
• Vouching dividend payments through Dividend Account, Profit and Loss Account, Cash Book, and shareholder receipts. Unclaimed dividends should be shown as a current liability in the Balance Sheet and deposited accordingly.
• Verifying gross dividends payable against paid-up share capital, reconciling net dividends payable with gross dividends and income tax deducted at source, and sampling individual member dividends.
• Reviewing unclaimed dividends with bank statements to ensure compliance with Act requirements.

Provisions Relating To Depreciation

Depreciation is crucial for an accurate financial position. The Act requires companies to provide depreciation for the current and past years to calculate divisible profits. Relevant provisions include:

• Section 205(10) specifies methods for providing depreciation, including the written down value method or straight-line method. Rates in Schedule XIV are minimums, and companies may use higher rates if assets have shorter useful lives.
• The Central Government may exempt companies from providing depreciation if it's in public interest.
• Depreciation on assets not exceeding Rs. 5000 should be 100%.
• Auditor's duties include ensuring adequate and reasonable depreciation, consistency in methods, recalculating depreciation for method changes, and disclosing revaluation effects on depreciation.
• Auditors must ensure proper disclosure of total depreciation, accounting policies, and any surplus/deficiency arising from asset disposal.

Audit Of Reserves

The auditor's role in auditing reserves is vital, especially as some reserves may not be available for dividend distribution. Here are the auditor's duties regarding reserves:

• Review of Reserves: Compare the current year's reserve balance with the previous audited balance sheet.
• Revaluation Reserve:
  • Ensure that increases in fixed asset book values due to revaluation are credited to the revaluation reserve. This reserve isn't realized and is thus unavailable for dividend distribution.
  • Confirm that accumulated losses and depreciation arrears aren't offset against the revaluation reserve.
  • Movement in Reserves: Ascertain the movement in reserves for the year and verify through board resolutions.
• Special Reserves: Examine these reserves to ensure compliance with legal or contractual provisions.
• Depreciation on Revalued Assets: Confirm that depreciation on revalued assets is based on the revalued figures. If additional depreciation is transferred from the revaluation reserve to the profit and loss account, ensure proper disclosure.
• General Reserves or Dividend Equalization Reserves: Verify changes in these reserves and ensure they're treated separately from other reserves.
• Sinking Fund:
  • Check compliance with the terms and conditions of each sinking fund.
  • Confirm that the funds are invested in earmarked securities.
• Capital Reserves:
  • Ensure that these reserves are created from capital profits only.
  • Confirm that any profit or loss from the realization or redemption of liabilities or acquisition of assets is recorded in the Sinking Fund Account.
• Capital Redemption Reserve:
  • Confirm that this reserve is created in accordance with Section 80 of the Companies Act, 1956, and is disclosed separately in the balance sheet.
  • Ensure that the reserve is used only for issuing fully paid-up bonus shares.
• Share Premium:
  • Verify that the premium is credited to the share premium account, which should be disclosed separately in the balance sheet.
  • Check compliance with Section 78 regarding the utilization of the share premium account.