Dividends and Divisible Profits of a Company

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:

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(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.

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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

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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

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(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:

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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

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(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.

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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.

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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;

(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.

(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.

(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.

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.

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.

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

(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.

(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.

(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.

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;

(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.

Dividends and Divisible Profits of a Company | Auditing