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Published by Rishabh Gupta

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D is trib u tio n
o f C a p ita l P ro fit
'X u d ito r 's D u ty R e g a rd in g D iv id e n d s
~ r o v i s i o n sR e l a t i n g
to D e p re c ia tio n
1 0 .6 .1
P ro v is io n so f th e A C L
1 0 .6 .2
A u d ito r's D u ty
A udit of Reserves
L etU sS u m
U p
Key W ords
A n s w e r s to C h e c k Y o u r P r o g r e s s
T e rm in a l Q u e s tio n s
1 0 .0
O B J E C T IV E S
A fte r s tu d y in g th is u n it, y o u s h o u ld b e a b le to :
e
E x p la in th e m e a n in g
of profit
i
i
e
d e fin e d iv is ib le p ro fits a n d d iv id e n d s
I
list different sources from
w h ic h d iv id e n d s c a n b e d e c la re d
i
@
d e s c r ib e th e p ro c e d u ra lfle g a l re q u ire m e n ts re g a rd in g p a y m e n ts o f d iv id e n d s
e
s ta te a u d ito r's d u tie s re g a rd in g d iv id e n d s
e
describe the provisions of the act regarding
d e p re c ia tio n a n d e n u m e ra te a u d ito r's
.*
d u tie s in
this regard
@
S ta te a u d ito r's
d u tie s in re la tio n
to reserves.'
-
1 0 .1
N IE A N IN GO F P R O F IT
D iffe re n t a u th o ritie s h a v e d e fin e d th e te rm
'p ro fit'
in different w ays. The econom ists

a s c e rta in p ro fits b y c o m p a rin g th e m a rk e t v a lu e s o f its n e t a s s e ts a t tw o a c c o u n tin g dates. They treat the increase or decrease in the net w orth as thep ro fit4 o s s fo r th e in te rv e n in g p e rio d . A c c o u n ta n ts , o n th e o th e r h a n d , v ie w

p ro fit d iffe re n tly . A c c o rd in g to
th e m , p ro fit c a n b e c o m p u te d a s a b o v e p ro v id e d b u s in e s s is g o in g to b e liq u id a te d . In
f a c t, b u s in e s s e n tity
is regarded
as going concern w hich is one of the fundam ental
a c c o u n tin g a s s u m p tio n s u n d e rlin in g th e p re p a ra tio n
of financial statem ents. Therefore,
the accountant does not lo o k at realisable value of assets as th e basis for com puting
p ro fit. M o re o v e r,j ti s v e ry d iffic u lt to m e a s u re o b je c tiv e ly th e m a rk e t p ric e of b u s in e s s
assets especially the fixed
assets. For an accountant, profit is the difference betw een
th e
revenue and the expenses of an accounting period. Inth isc o n te x t, th e ju d g e m e n t in t h e
c a s e o f S p a n is h P ro s p e c tin g C o . L td . (1 9 1 1 ) is n o te w o rth y
"....if th e to ta l a s s e ts o f tlie b u s in e s s a t tw o d a te s b e c o m p a r e d , t h e in c re a s e w h ic h
th e y s h o w a t th e la te r d a tea sc o m p a re d w ith th e e a rlie r d a te ( d u e a llo w a n c e s , o f c o u r s e ,
b e in g m a d e f o r a n y c a p ita l in tro d u c tio n
in to o r ta k e n o u t o f t h e b u s in e s s in th e
m e a n w h ile ) re p re s e n ts , in s tric tn e s s , th e p ro fits o f th e b u s in e s s d u rin g th e p e rio d in
q u e s tio n . T h e s tric t m e a n in g o f
'profit' is rarely
observed in draw ing up the accounts of
firm s a n d c o m p a n ie s.... C e rta in
assum ptions have becom e so custom ary in drawing up
w ith the definition
to w h ic h
I have referred".
Y ou
m ay also notefro m
th e a b o v e th a t a c c o u n tin g p o lic ie s p l
in determ ination of true profits. Y ou
m u s t h a v e n o tic e d th a t t
a c c o u n tin g p o lic ie s in v o g u e w h ic hm a y b e fo llo w e d
b y
d iffe
instances, depreciation on fixed assets m ay be charged on stra
w ritten -d o w n
v a lu e m e th o d . D e p e n d in gup011 th e a c c o u n tin g p
e n tity , th e fig u re o f p ro fit w o u ld
a ls o v a ry . S im ila rly , in v e n to
n e t~ .e a lis a b lew h ic h e v e r is lo w e r . T h e c o s t m a y
b e a d o p te d b
b a s e d
on LIFO , FIFO , or specific identification
m e th o d , e tc . E
d ifferen t estim ate for w riting
off deferred revenue expenditure
d o u b tf~ ~ l
d e b ts w o u ld
d e p e n d
u p o n
th e ju d g e m e n t o f th e m a n a
Thus there can
b e n o s in g le m a g ic a l fig u re o f p ro fit w h ic h
w
circum stances.
In any case, it is necessary

th a t p ro fits a re d e te rm in e d a c c o rd accepted accountingp r i n c ~ p l e sa s a l s o h a v i n g r e g a r d t o t h e l e a p p lic a b lc . A n y

o v e rs ta tc m e llt o f p ro fit w o u ld re su lt in p a y m e c a p ita l c o n s e q u e n tly le a d in g to re d u c tio no f c a p ita l a n d a s s u c v o id .T heu n d e rs ta te m e n t o f p ro fit, o n th e o th e r h a n d , a ffe c ts and leads to creation of secret reserves w hich

is p ro h ib ite d
u n
1 0 .2
D IV IS IB L EP R O F IT S A N D D N L D E
-You m ay note that the term
" d iv is ib le
p ro fits"
has not been d
A ct. First of all it isl l e c e s s a r y

to ascertain correct prolits by accepted accounting principles. T hen, it is not necessary that am ongst ow ners of the enterprise and thus consum ed. In fact retained by the enterprise to finance its grow th and diversific th e A c t a ls oiin p o s e s c e rta in re s tric tio n s o n th e e x te n t to w h i a m o n g st its m e m b e rs . A c c o rd in g ly , th e p a rt o f th e p ro fits

o f
le g a lly d is trib u te d
to its m e m b e r s is k n o w n
a s 'd iv is ib le p ro f
d iv is ib le p ro fits
w h ic h

is a c tu a lly d is trib u te d is k n o w n a s 'd iv g e n e ra lly a c c e p te d p rin c ip le s o f a c c o u n ta n c y , th e re le v a n t p ro A c t, 1 9 5 6 a n dth e v a rio u s ju d ic ia l p ro n o u n c e m e n ts in d iffe re g u id in g fa c to rs ind e te rm in in gd iv is ib le p ro fits . L e t u s d is c u s fo llo w in g p a ra g ra p h s .

1 0 .3
P R O V IS IO N S O F THE COMPANI
Section 205 of the A ct enum erates the sources from
w h ic h d
m akes it com pulsory for a com pany to provide for depreciati
dends. A
com pany m ay also be asked to transfer som e part o
in te n d s to p a y
d iv id e n d e x c e e d in g c e rta in lim it. It a lso la y s d
d e c la ra tio n
a n d p a y m e n t o f d iv id e n d s in c lu d in g th e m a n n e r o
o r u n c la im e d d iv id e n d s . I n th is th e coitext, it is equally
im p
pronouncem ents on
the issue are givend u e a tte n tio n .

im m e d ia te ly p re c e d in g fiv e y e a rs . T h is is s u b je c t to af u ra te of d iv id e n d s h o u ld n o t e x c e e d te n p e r c e n t o f th e p com pany.

Let us now
d is c u s s e a c h s o u rc e b rie fly a lo n g w ith c o n d itio n s a tta c h e d th e re to :
D ividend out of C urrent Y ear Profits
A
c o m p a n y h a s toc o m p ly w ith th e fo llo w in g w h ile
d iv id e n d s o u t o f th ep ro fits
of the current year:
b )
T h e to ta l a m o u n t t o b e d r a w n fro m
the reserves should
p a id -u p c a p ita l a n d frce reserves of the com pany.
a )
P ro v is io n fo r d e p re c ia tio n :T he p ro fit fo r y e a r w o u ld b e a rriv e d a t o n ly a fte r
p ro v id in g d e p re c ia tio n b o th
for the current year and for any past years.
C )
The am ount draw n from

r e s e r v e s s h o u ld b e u tilis e d , in the losses incurred in the current year, if any. Only the s u c hs e t o ff c a n b e u tilis e d fo r p a y in g d iv id e n d .

b )
Set-off in case of past losses: W here a com pany has incurred a loss in any
p re v io u s year(s), it should be set off against its profits of the cum ent year o r of
any previous year:
d )
The balance of reserves after such w ithdraw al should no
cent ofth e p a id -u p
c a p i t a l o f t h e c 'o m p a n y .
'I )
the am ount of loss for the previous year(s),or
For the purpose ofth e a b o v e re q u ire m e n ts , th e te rm
'r e s e r v e s

reserves created on revaluation of fixed assets as w ell as any im p o rta n t to n o te th a t th e a b o v e c o n d itio n s a p p ly o n ly w h e re 'reserves'. T hus, a com pany can declare dividend out of the b years w hich has not been transferred to any reserve (i.e., b ala sheet underth e h e a d

'S u r p lu s ') w ith o u t c o m p ly in g w ithth e a
i i )
th e a m o u n to f depreciation provided for such previous year(s), w hich ever is
lo w er.
F o rexaillple: a com pany incurred losses for the year 1994-95 and 1995-96a s per
th e d e ta ils g iv e nbeIow :
Y ear
A m ount of Loss after
P ro v isio n fo r
c h a rg in g d e p re c ia tio n
d e p re c ia tio n
R s.
R s.
1 9 9 4 -9 5
2 5 ,0 0 0
4 0 ,0 0 0
1 9 9 5 -9 6
5 5 ,0 0 0
4 5 ,0 0 0
D iv id e n d o u to fM o n e y s P ro v id e db y th e C e n tra l o r a S ta
T he central governm ent or a state governm ent m ay, in som e

paym ent of a certain i a t e o f d iv id e n d to in d u c e in v e s to rs to m com panies w here the returns are uncertain or w here the gestat W here any m oney

is p ro v id e d by
a governm ent in pursuance
g iv e n b y it, th e m o n e y c a n b e u tilis e d f o r th e p a y m e n t o f d iv
D u rin g
1996-97,the company earned profit ofR s .1 ,2 5 ,0 0 0 a n d w is h e d to d e c la re
dividends. In such as jtu a tio n , th e c o m p a n y s h a ll h a v e to s e t o f f R s. 7 0 ,0 0 0

(R s. 105,000 for the year 1994-95 and R s. 45,000 for the year 1995-96) against th e p ro fits of c u rre n t y ear. T h e re fo re , th e d istrib u ta b le a m o u n t in 1 9 9 6 -9 7 w o u ld b e R s. 5 5 ,0 0 0 (R s.1 ,2 5 ,0 0 0 -R s . 7 0 ,0 0 0 ) .

1 0 .3 .2
ProceduraV LegaI R equirem ents

T h e p ro c e d u re f o r d e c la ra tio n a n d p a y m e n t of d iv id e n d s is g o 2 0 7 o f th e A c ta n d th e p ro v is io n s c o n ta in e d in th e A rtic le s of 85-94 of TableA

o f S c h e d u le I to th e A c t, d e a l w ith v a r io u s m ay be noted that a com pany can prescribe different rules. T surnm arised as follow s:

C )
T ransfer of Profitst o R eserves: A
c e m p a n y m u s t re ta in a d e q u a te fu n d s to
'
fin a n c e its g ro w th . T h e re fo re , th e law
requires thata com pm y m ust transfer
prescribed am ount out of its current profits to reserves in case it intends to declare
or pay dividend exceeding 10%
o ni t sp a id u p c a p ita l. H o w e v e r, th e re s h a ll be n o
b a rona c o m p a n y ifi t v o lu n ta rily tra n s fe rsa h ig h e r p e rc e n ta g e of its p ro fit to th e
reserves in accordance w ith such rules as m ay be m ade by the C entral~ o v e r n k e n t
i nth is b e h a lf. A s a t p re s e n t, th e re le v a n t ru le s a re as fo llo w s
1
A u th o rity f o r d e c la r in g d iv id e n d : ' ~ e ~ u l a t i o n
85 of Ta
com pany in
general m eeting may
d e c la re d iv id e n d s , b u t
th e a m o u n tr e c o ~ n m e n d e db y
the Board".
R ate of dividend proposed
A m ount to be transferred
to the reserves
+'
,
(a s p e rc e n ta g e o f p a id -u p c a p ita l)
i )
E x c e e d in g 1 0 %
but not
-e x c e e d in g 1 2 .5 %
N o t, le s s th a n2 .5 %
of current profits
2

D iv id e n d p a y a b lei nc a s ho n ly : A c c o rd in g to S e c tio n p a y a b le in c a s h . H o w e v e r, th e re is n o p ro h ib itio n a s to reserves by

m eans of issue of bonus shares or paying u
the tim e being unpaid, in respect of any shares held by
3
T im e L i m i t f o r p a y m e n t o f d iv id e n d : T h e d jv id e n d s d
re q u ire @ to b e p a id w ith in fo rty -tw o d a y s of su c h d e c la
'
is s u ffic ie n t if th e c h e q u e o r w a rra n t in re sp e c t o f th e d
w ith in th e p re s c rib e d p e rio d Of forty-tw o days.
i i )
E x c e e d in g 1 2 .5 %
but not
exceeding 15%
i i i )E x c e e d in g 1 5 %
but not
e x c e e d in g2 0 %
iv )
E x c e e d in g 2 0 %
N o t le s s th a n 5 %
of c u rre n t p ro fits
5
N ot less than7 .5 % of current profits
4
Unpaid dividend to be transferred
t oaspecial divid
.
Section 205A (a), the com pany has been

g iv e n 4 1 0 d a y s d e c la ra tio n o f d iv id e n d w ith in w h ic h it m u s t p a yd iv ih e w arran tst oa lls h a re h o ld e rs e n title d to th e p a y m e n t o f d

N o t le s s th a n 1 0 %
o f
c u rre n t p ro fits
o rto th e ir b a n k e r s : U nder Section 206 of the A ct, dividend in respect of any
sharc shall be paid by a com pany-(i) to a registered
holder of such share, or to his
o rd e r, o r to h is b a n k e r; o r (ii) in the case of a share w arrant issued
in respect of
th e s h a r e in
pursuance of Section
1 1 4 , to th e b e a r e r o f s u c h w a r r a n t o r to h is
b a n k e rs .
7
R ig h t t o d iv id e n d , r ig h ts a n d b o n u s s h a r e s to b e h e ld in a b e y a n c e , p e n d in g
r e g is tr a tio n (S e c tio n2 0 6 A ): A c c o rd in g to th e n e w
S e c tio n 2 0 6 A
inserted by the
Com panies (Am endm ent) Act, 1988, if any instrum ent of transfer hasb e e 1 1
delivered to any com pany for registration, and the transfer of' such shares bas not
been registercd by
th e c o m p a n y , th e n th e c o m p a n y
will be required
to (i) to
transfer the dividend in respect of such shares to the U npaid
D iv id e n d A c c o u n t
(9 :c tio n
2 0 5 A ), a n d th e a m o u n t o f th e d iv id e n d
w ill n o t b e p a id
to the transferee
as specified
in the instrum ent of transfer unless the registered
holder of such
s h a re sa u th o ris e s th e c o m p a n y in w ritin g to d o s o , a n d
(ii) k e e p in
abeyance any
o ffe r o f rig h ts s h a re s S e c tio n 81(1)(A ) or any issue of fully-paid bonus shares
S e c tio n2 0 5 (3 )in r e s p e c t o f s u c h s h a r e s .
8
R ig h t t o d iv id e n d :T h e rig h t o f c la im in g d iv ~ d e n da ris e s o n ly a fte r th e d e c lslra tio n
-
o f d iv id e n d i n th e c o m p a n y 's g e n e ra l m e e tin g . It is o n ly
a fte r th is th a t d iv id e n d
b e c o m e s a d e b t. D iv id e n d
o n c e d e c la re d in th is w a y
cannot be revoked, unless it
is done so w ith the consent of the shareholders.
9
N o d iv id e n d fo r p a s t y e a r s : D ividend cannot be declared for past yearsi n respect
of w hich the accounts have already been closed in a previous annual general
,
m e e tin g . It is a ls o b e y o n d
th c p o w e rs o f th e c o m p a n y t o
d e c la re a fu rth e r d iv id e n d
a fte r d e c la ra tio n o f d iv id e n d
at the annual general m eeting,
1 0
P r o h ib itio n o n d e c la r a tio n o f d iv id e n d in c a s e o f fa ilu r e to r e d e e m p r e fe r e n c e
s h a r e s :S e c tio q2 0 5 (1 0 B ) p ro h ib its a c o m p a n y , w h ic h f a ils lo c o m p ly w ith th e
re q u ire m e n is
o f S e c tio n8 0A
re la tin g to re d e m p tio n
of any preference shares
is s u e d
by it, from
d e c la rin g a n y d iv id e n d o n its e q u ity s h a re s s o lo n g as th e
fa ilu re c o n tin u e s .
1 0 .3 .3
S ig n ific a n t L egalC ases
L ee v. N euchatel A sphalte C o. Ltd. (1889): The suit was filed by
as h a re h o ld e r
seeking to restrain
th e d ire c to rs
of the com pany from
d is trib u tio n
o f d iv id e n d
to the
p re fe re n c e s h a re h o ld e rs w ith o u t p ro v id in g f o r d e p re c ia tio n o f th e c o m p a n y 's p ro p e rty .
T h e A rtic le s o f th e c o m p a n y s p e c ific a lly
s ta te d th a t th e directori w ere not bound to set
apart funds fo r renew al of replacem e~lto f any lease of m ine, or for any other property
or concession
of the com pany. H ow ever, the directors w ere from
tim e to tim e p ro v id in g
la r g e a m o u n ts fo r w ritin g o ff a s s e ts , th o u g h in th e y e a r to w h ic h
th e c a s e re la te d , th e y
'
h a d
not m ade any such provision, It w as held in this case w as "a com pany, em pow ered
lo do so by its A rticles of A ssociation
m a y d is trib u te d iv id e n d s w ith o u t m a k in g g o o d
1
the depreciation of wasting nssctr~".From
th ea u d ito r's p o in t o f v ie w , an im p o rta n t p o in t
m a d e in th e ju d g e m e n t isa s f(l1 lo w s:
" Ifacom pany is form ed
to a c q u ire o r w o rk a n y p ro p e rty o fa w a s tin g n a tu re , e .g ., a
m in e . q u a rry
o r p a te n t, th e c a p ita l e x p e n d in a c q u irin g th ep ro p e lty m a y
be regarded as
a sunk and gone, a ~ l d a n y e x c e s s o f m o n e y o b t a i n e d b y w o r k i n g t h e m i n e
o v e r th e c o s t
i t sp r e f e r e n c es h a r e h o l d e r s
w ith o u t p ro v id in g f o r d e p re c ia ti
g o o d w ill, le a s e s , e tc ., th o u g h
in earlier years it had
d u ly d o
s h a re h o ld e r m oved the Court to stop the com pany from
g iv
the court refused
to in te r v e n e , a p p ly in g th e p rin c ip le la id
d
A s p h a lte C o . it w a s d e c id e d th a tacom pany
cannot be rest
out of current profits for the reason that no provision has b
fixed assets.
Crabtree, Thom as v. Crabtree(1 9 1 0 ):A
trust w as create
te s ta to r's w ife . T h e tru s te e s h a d , b e fo re a sc e rta in in g th e p ro
trh st, p ro v id e d
d e p re c ia tio n
on the m achinery em ployed the
a n
a c tio n
p ra y in g
for disallow ance of depreciation. The C o
h o ld in g th a t d e p re c ia tio n
h a d
b e e n p ro p e rly p ro v id e d . T h e
c h a r g e s in r c s p c c t o f d e p r e c i a t i o n
of fixed assets ought pro
a s c e rta in m e n t o f p ro fits f o r d is trib u tio n .
A k m o n ia S o d a C o .v . ~ r t h u rC h a m b e r la in(1 9 1 8 ): T h e
th e c o m p a n y
s h o w e d a lo s s o w in g m a in ly
to th e d e b its o n
and m achinery, m ortgage and debenture interest, and direct
m adc by
th e c o m p a n y to r e l c h
w a te r, a h ith e rto u n k n o w n
d is c o v e re dw h ic h , in th e d ire c to rs ' o p in io n , w a s a re a s o n a b
th e v a lu e o f c o m p a n y 's p ro p e rty .T h e a p p re c ia tio n
m ade
i n
t o w ritc off losscs disclosed by
th e P ro fit a n d L o s s A c c o u n
d iv id e n d w a s d e c la re d
on preference shares out of the prof
a g a in st th e d ire c to rs to m a k e th e m
lia b le f o r p a y in g d iv id e
re je c te d
th e p le a h o ld in g th a t re v a lu a tio n
o f p ro p e rly
was b
in fo rm a tio n had been
h e ld
b a c k
S ro m
the shareholders.,
H eldth a c ,a c o m p a n y
m ay

w rite up its assets as a result o m a y d iv id e c u rre n t p ro fits w ith o u t first w ritin g o ff p rio r lo w h i c l ~f o r b i d s a c o m p a n y f r o m

s e ttin g o ff a n a p p re c ia tio n
assets, asa s c e r t a i n e d
b y
a b o n a fid e v a lu a tio n
against losse
d iv id e n d in th is c a s e ' w a s n o t in fa c t p a id
o u to fc a p ita l, b u
I
C heck Y our ProgressA
1
D e fin e d iv is ib le p ro fits .
2
L ist sourccs of dividends.
1
.................................................................
3
State ;vhether
the follow ing statem ents are T rue or F
i )
D ividend fora year can be paid
o n ly o u t o f p r

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