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Auditor's Role in Determining Divisible Profit
1.
2. What do you mean by profit?
It is known to all that, profit earning is the main
objective of every business concern. The determination of
profit is of great importance, because, the true profits of a
concern not only affect its properties but also the income
tax authorities as well as the managers, directors,
shareholders etc. whom are to be paid a percentage of the
net profit. However, what is profit? It is not so easy to
answer this question. Because, different persons,
authorities, justice have defined profits in different ways:
These are-
Some writers say, “Generally speaking the profit of
a business during a given period is the excess of income
over expenditure for the period.”
3. Others defined-, “It is the excess of the assets over
liabilities and the capital between the two periods.” Another
case decision, it was in 1892, Lord Herschell in Gresham.
life Assurance society Vs styles, 1892. “Profits are
ascertained by setting against the income earned, the cost
of earning it.”
In 1925, Union Bank of Alahabad-,
“Profits means profits realised.”
After above discussion, it is clear that, after deduction the
total expenses from the total revenue which is exist, called
profit.
4. THE CONCEPT OF THE PROFIT
The question of the determination of the profit is of
great importance. Its determination affects several people
in different walks of life e.g. proprietors, income-tax-
authorities, shareholders, directors etc. Consequently, it is
a very important item in determining the correct profit of a
concern. Authorities on the subject have defined the word
“profit” in different ways.
(1) Generally speaking, the profit of the business during
a given period is the excess over the expenditure for the
period.
(2) It is the excess of assets over the liabilities and the
capital between the two period.
5. DIFFICULTIES IN THE DETERMINATION OF PROFITS
Some of the basic complications which lies in the
determination of profits are listed below:
(1) How to value the assets at the close of the period?
(2) How should the liabilities be valued?
(3) Whether the previous losses must be written off
(4) Whether or not it necessary those reserves, special
provisions for depreciation etc, be provided for?
(5) The question of capital expenditure being treated as
revenue expenditure and vice versa, is to be given a
careful consideration.
(6) A careful consideration should be given to those
expenses the benefit of which may be derived in the
subsequent accounting period.
6. What is business profit or revenue profit?
Business or revenue profit is a regular profit
from day to day activities, that is after deduction
the current expense and depreciation of the
assets which exists is called business or revenue
profit.
On the other hand, capital profit is a irregular profit
which we get from capital transactions like selling
of capital assets.
7. Differences between business profit and
capital profit are shown below:
(i) Nature: Business profit is the profit earned
from the normal activities of business. on the
other hand, capital profit is the profit earned
from the transaction in capital.
(ii) Distribution:- Business profit can be
distributed among the shareholders as
dividend. But, capital profit should not be
distributed as dividend from the business view.
8. (iii) Usage: Business profit can be used as
reserve in some cases. On the other hand, capital
profit may be used for expansion of business and
for meeting contingent liabilities.
(iv) Determination: Business profit is determined
from the revenue concerned account or profit and
loss account. But, capital profit is derived from
different accounts.
(v) Trading concern: Business profit is a trading
profit. Contrast, capital profit is not trading profit.
(vi) Recurrence: Business profit occurs
frequently. On the other hand, capital profit is not
recurrent.
9. CONSEQUENCES OF INCORRECT DETERMINATION OF
PROFIT
If the profit, are not correctly arrived at, it may result as
explained below:
(1) Under-statement of profit will lead to the following
disadvantages:
(a) Lowering the value in the market.
(b) Depriving the shareholders of dividends to which
they are entitled.
(c) Reducing the commission on profits payable to the
manager.
(2) Over-statement of profit will result as following :
(a) Distribution of capital in the form of dividend.
(b) Payment of managing agents as percentage of
profit in excess of the entitlement.
(3) Over-valuation or under-valuation of assets and liabilities
would result in misrepresentation of the balance-sheet.
10. IMPORTANCE OF PROPER ASCERTAINMENT
OF PROFITS
In the case of business owned by individuals
and partners, the proprietors may ascertain their
profits in any way they like, because other parties
are not interested therein. However, the position
with regard to the limited companies is quite
different. Apart from present shareholders of the
company, there are other persons such as the
prospective shareholders, debenture-holders,
creditors, employees etc, who are interested in this
profit. Therefore, it is important that the profit of the
company should properly ascertained, failing which
the various parties would be affected as under:
11. (1) If profits are understated, they result in depriving the
present shareholders of their dividends to which they are
entitled. Further the market value of the shares also
decline.
(2) An over statement of the profits may result in an
improper payment of dividends.
(3) Dividends may be paid out through an overstatement
of the profit. Thus dividends may be paid out of capital of
the company and it may become insolvent and ultimately
go into liquidation.
(4) An overstatement of the profits may result in
increased remuneration payable to managing agents,
thereby causing a corresponding loss to the company.
12. CONCEPT OF DIVISIBLE PROFIT
The term ‘divisible profit’ means all profits that can be legally
distributed to the shareholders of the company. Regulations
98 of the schedule-1 of the Co. Act reads as under:
“No dividends shall be paid by company otherwise than out of
profits of the year or any other undistributed profits.”
No dividends shall be declared or paid by a company for any
financial year out of the profits of the company made from the
sale or disposal of any immovable property or assets of a
capital nature comprised in the undertaking or any of the
undertaking of the company, unless the business of the
company consists, whether wholly or partly, of selling and
purchasing any such property or assets except after such
profits are set off or adjusted against losses arising from the
sale of any such immovable property or assets of a capital
nature.
13. The company law does not lay down the
manner in which the profit of the company is to
be ascertained. It also does not define as to what
profit can be distributed for dividend purposes.
The question then is:
What are the guiding principles to be
applied in determining whether a particular profit
is available for distribution in the form of dividend
or not?
The following guiding principles must
invariably be kept in mind:
14. (1) In no circumstances a dividend can be paid out of
the capital.
(2) In every case the requirements of the
memorandum and articles of association of the
company must be faithful, complied with.
In the following cases dividends will be considered to
have been paid out of the profits:
(a) If any expenditure locatable to revenue is charged
to capital with a view to swelling the profit of the
company improperly.
(b) If a company paid a dividend in spite of the fact that
the profit and loss account indicates the loss and there
are no other undistributed profits.
15. (c) If a company distributes the sale proceeds of one
of its fixed assets.
The reasons as to why the company Law prohibits the
payment of dividend out of the capital are briefly
narrated below:
(i) The payment of dividend out of the capital amount
to voluntary reduction of capital without the permission
of the court.
(ii) If the payment of dividend out of capital is
authorized by the memorandum or articles of
association, it is illegal, as it is ultra quires the
Ordinance.
16. Important consideration in determining
Divisible profit.
While determining divisible profit some factors are to
be considered. These factors are:-
1. Transfer to reserve:-
(a) Statutory Reserve, i.e. the reserve which is legally
required to be created e.g. in the case of banking
companies twenty percent of the profits must be transferred
to reserve account or in the case of electricity companies
contingency and tariff reserve has to be created.
(b) Provision for reserve according to the Articles of
Association.
(c) Contractual Requirements, e.g. it the terms of the
issue of debentures or redeemable preference shares
provided that reserve should be created of their redemption
it must be provided.
17. 2. Dividend Equalization Reserve:- Sometimes the
profits of the company fluctuate violently from year to
year. In such a circumstances, it is desirable to
monster a part of profits before declaring dividend to
the dividend equalization reserve to maintain a
uniformity in the declaration of dividends.
3. Cash Requirements:- If the working capital is just
sufficient, it is not advisable to declare a dividend, if it
is declared it will have to be paid to the shareholders
within 42 days and thus the working capital will be
reduced.
18. 4. Past policy:- While declaring dividend the directors
should follow a consistent policy. On account of
fluctuation in the rate of dividend the value of the
shares in the market will be very much affected.
5. Preference shares:- Before declaring dividend to the
equity shareholders, preference shareholders must be
paid dividend.
6. Legal decision:- The legal decisions have laid down
the following principles for the distribution of profits:-
(a) The shareholders capital can not be used to pay
dividends and
(b) A dividend can only be paid out of bona fide
surplus.
19. Auditors duties regarding divisible profit.
There are enough or sufficient duties of a company
appointed auditor regarding company divisible profit at
the time of determining divisible profit the directors have
to follow the provisions of law and G.A.A.P. So in case of
company divisible profit, the auditor has to justify or
examine provisions of articles of association, provisions
of law. Case law decisions etc. Auditors duties regarding
divisible profit are discussed in below.
1. Verification of sources:- Received profit from normal
function of company whether this profit is distributed to
the shareholder as divisible profit or not, that must be
examined.
20. 2. Verification of divisible profit:- In case of
calculation of divisible profit of company, whether
the proper depreciation of depreciable assets is
charged or not and proper principles and procedure
are followed or not that must be verified by auditor.
3. Verification of legal decisions:- Generally if the
case dividend from capital profit is declared
whether different legal decisions are followed or not
in this case that must be seen.
4. To Examine Capital:- In no case. the dividend
will given from capital according to his own
knowledge, capacity and experience
21. the auditor must be free from indebt or sure that capital
is not damaged and there is no capital within divisible
profit.
5. To examine reserve account: Before declaration
dividend of the directors of company whether a specific
portion from current profit of present year is transferred
to reserve account or not that must be examined.
6. Verification of making past losses:- After past
compensation whether the divisible profit is determined
or not that must be examined.
7. Verification of Articles of Association:- Auditor
should see that whether there is any provisions relating
to divisible profit in articles of Association.
22. 8. To Examine the decisions of the meeting:- How
many decisions of meeting of share holder and
directors of the company are taken that must be
justified.
9. Verification of Taxation:- whether the income tax
and other tax on company divisible profit are
managed efficiently or not that must be examined
The auditor can be danger free after proper
verification of above discussed contents. In this case,
if the auditor shows negligency then the auditor will
be liable for such negligence.
23. DIVIDEND
A Slice of profit which goes to the credit of the
shareholders after meeting obligation to different
parties is called dividend.
Auditors duties and responsibilities regarding payment of
dividend:
• To consider articles of association.
• To examine the section of the Act.
• To examine the minutes book.
• To examine the register and register book.
• To examine the calculated dividend.
• To examine the Bank Account.
• Duties regarding payment of Dividend.
• Duties regarding unclaimed dividend.
• Duties regarding “Table A”.
• To examine bonus share issued.
• To examine the paid up dividend and unclaimed dividend.
24. What is Interim Dividend
Interim dividend: Interim dividend is the most important
motivating factor. When a company declared dividend
before at the end of the accounting period, it is called
interim dividend. If it is mentioned in the article of
Association, then the board of directors can declared
interim dividend after conforming about probable profit of
the company before at the end of accounting period.
Interim amount is prepared to determine interim profit
before declaring interim dividend.
Payment of interim dividend:
The following work should be done by the auditor in
respect of checking the payment of dividend.
25. 1. Interim accounts to be prepared:
The profits made by the company must be
carefully estimated. For this purpose it is advisable to
prepare interim accounts for the half year. Where
however, the business is of such a nature that the
percentage of gross profit on turnover is more or less
constant year by year and there are no unusual factors
during the current year which may affect the figure of
profits, it may be possible to dispense with the taking of
stock and the preparation of the interim accounts.
2. Remainder period conditions to be anticipated:
A careful inquiry should be made into the
conditions of trade and prospects for the remainder of
the year, because it is quite possible that the profit
earned during the first half year may be swallowed up
by a loss in the second half year.
26. 3. Cash Position to be watched:
Cash position of the company should be examined
since it would be inadvisable to pay an interim dividend,
although there may be profits, if such payment may
unduly deplete the working capital of the company.
4. Rate to be lower than final dividends:
If it be decided to pay an interim dividend the rate
fixed should preferably be lower than the estimated rate
for the whole year, because it is better that the finial
dividend may be higher than the interim.
The above task must be done by the auditor to
check the payment of dividend.
27. Difference between interim dividend and
dividend
1.Definifion:
Interim dividend: When the dividend of a company
is declared before at the end of the accounting period, it is
called interim dividend.
Dividend: The part of the profits of the company
which is distributed to the shareholders at the end of period,
it is called dividend.
2. Payment of time:
Interim dividend: Interim dividend is paid in the
meantime of the accounting period.
Dividend: Dividend is paid at the end of the
accounting period.
28. 3. Amount:
Interim dividend: The amount of interim dividend
is lower than dividend.
Dividend: The amount of dividend is higher than
interim dividend.
4. Rate:
Interim dividend: Generally the rate of interim
dividend is lower than dividend.
Dividend: the rate of dividend is higher than
interim dividend.
These are the important difference between
interim dividend and dividend.
29. Profit prior to incorporation
Legally the shareholders have no right to share such
profits as were made by the company at a time where it
had not come in to existence. Therefore, distribution of
dividends out of profits prior to incorporation is illegal.
However, profits prior to incorporation in the form of bonus
shares. The balance of the profit earned prior to
incorporation may be utilized in writing off goodwill or, If
there be no good will, in writing off the fictitious e.g.,
preliminary expenses, lender writing commission.
brokerage on shares, discount on share and debentures
etc, or may be carried forward as capital Reserve not
available for dividend.
30. Can a company distribute the dividend without
recovery of past losses?
Based on sound financial policy, if there are past
losses and profit has been made in the current year, no
dividend should be declared until the past losses have
been wiped off.
The directors may, in the honest exercise of their
discretion and subject to the Articles of Association of the
company, divide a profit arising in the period of account
even though the losses of period remain unabsorbed.
In this respect the sound case low from which
guidance can be sought is described there in:
31. The Ammonia soda co. Ltd vs. Arther cham berlain and
others (1918). In the year 1910, the company’s profit and
loss account showed a debit balance of 12,970 For the
purpose of the balance sheet issued by the company as on
31st July, 1911, the value of the company’s land was
appreciated by 20,542. As a result of revaluation and this
helped to wipe off the debit balance on the profit and loss
account. The company made profits subsequent to 31st July,
1911, and paid dividends there from.
Based on the judgment given in the above case, it is
clear that a company is not bound to make good previous
debit balance on the profit and loss account before dividing
current profits. From the view point of sound finance, it may
seen desirable to apply current year’s profits in making up
lost capital but legally, if it is not so applied and utilized in
payment of a dividend, it will not amount to a reduction of
capital. There is thus no legal obligation to provide for lost
capital out of current profits.
32. Can capital profit be distributed to
the shareholders as dividend?
Ordinarily capital profits are not available for distribution
as dividends. However, they could be distributed as
dividend provided:
(1) The profit is a realized one.
(2) If the profit remains after the whole of the other
assets have been valued, and
(3) If the distribution of a dividend out of such profit is
permitted by the Articles of Association of the company.
However, the capital profits, whether realized or not, can
always be distributed in the form of bonus shares, since
the assets are not there by reduced in any way.
One of the leading case in this respect is briefly
discussed below.
33. Lubbock vs. British Bank of south America
Ltd (1892).
The company had sold its business in Brazil and
had realized upon this sale a profit of 2,00,000. It was
held that this profit was available for distribution as
dividend.
Finally, we can say that, capital profit can be
distributed as dividend, if it is permitted by the Articles of
Association.
34. Can dividend be distributed without charging
depreciation on fixed and floating assets?
Depreciation is charged or not on fixed and floating
assets before distributing dividend are discussed below
with different case decision basis.
1. Verner vs. General and Commercial
Investment Trust ltd. (1894). It is necessary to make good
any loss or depreciation of floating assets before arriving at
profits available for distribution.
This case was decided in the court of appeal on the
7th April, 1894. The decision was to the effect that an
injunction to restrain a company from paying a proposed
dividend out of current profits, on the ground that the
capital of the company is not intact, must be refused if the
company is solvent and acting within its articles.
35. 2. Lee vs. Neuchatel Asphalte company Limited
(1889). A company is under no legal obligation to make
good the depreciation of its fixed assets, provided:
(a) There is nothing in its articles requiring it to do so,
and
(b) That it retains sufficient assets to discharge its
liabilities.
This case was decided in the court of Appeal on 9th
February 1890, where it was held that a company, if allowed
by its articles of association, may provide for the distribution
of profits arrived at before making good the depreciation of
fixed assets.
From the above case decision it may be said that
dividend can be distributed, if depreciation of fixed and
floating assets is not compulsory by article of association.