University of Jahangir Nagar

Institute of Business Administration

BBA Programme 30th Batch

Auditing and Taxation
Lecture 11

Course Teacher:
Shish Haider Chowdhury
shishchowdhury@yahoo.co.uk
018 1922 5594

10 May 2024
 Divisible profit & Dividend
1. 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.”

2. 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.

3. 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.

4. Difficulties in the determination of profit

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.
5. 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 an irregular profit which we get from capital transactions like selling of
capital assets.

6. 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;
(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 regularly. On the other hand, capital profit is not
recurrent.

7. Consequence 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.

8. Importance of proper ascertainment of profit

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:
(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.

9. 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.

10. 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:

(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 Capital: (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. (c) If a company distributes the sale proceeds of
one of its fixed assets.

11. 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 vires to the Act.

12. 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.

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.

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 cannot be used to pay dividends and (b) A dividend can only be paid
out of bona-fide surplus.

13. 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. Auditor’s 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.

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 be given from capital according to his own
knowledge, capacity and experience. 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.

8. To examine the decisions of the meeting: How many decisions of meeting of shareholder 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 negligence then the auditor
will be liable for such negligence.

14. 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 Company’s 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.

15. What is 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.

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.

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 final
dividend may be higher than the interim. The above task must be done by the auditor to check the
payment of dividend.

16. Difference between interim dividend and dividend

1. 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.

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.

17. 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.

18. 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 law from which guidance can be sought is described there in:

The Ammonia soda co. Ltd vs. Arther chamberlain 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 be 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.

19. 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.

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.

20. 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.

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.