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Topic: Divisible Profit B.Com Part II Auditing Notes  (Read 2331 times)
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« on: July 16, 2010, 08:11:59 PM »

Chapter 8 - Divisible Profit

* Divisible Profit

* Concept of Profit

* Principles of Divisible Profit

* Importance of Correct Profit

* Secret Reserves

* How Secret Reserves is Created

* Advantages of Secret Reserves

Introduction of Divisible Profit

Those profits are term as the divisible profit, which is legally distributed to the shareholders of a company as dividend.

Factors of Divisible Profit

The following are the main factors, which influence the divisible profit.

1. Capital Profit

The divisible profit ca be paid, if there is some capital profit or gain.

2. Capital Loss

If some part of the capital is lost or there is capital loss the dividend can be paid out of the current profits without making any provisions for any capital loss.

3. Depreciation

The depreciation is charged before the distribution of the divisible profit

4. Transfers of Reserves

Under company ordinance 1984,

Before declaring dividends the directors have powers to make such reserves as they may think proper.

Concept of Profit

Like the term "value" in economics accountants have used the word. "Profit" for many years without assigning a definite meaning to it. This state affairs has given rise to much informed criticism of accountants and their work added to this is the difficulty caused by the divergence that exists in the concept of the profit between the economist and an accountant for the purpose of settlement of claims of parties to their shares in the profit of a business.

Principles of Divisible Profit

1. Articles of Association

The articles of associations are the rules of the company for managing the business activities. The articles prescribe the rules for divisible profit. The directors are entitled to distribute the profits under the rules. The cannot exceed the prescribed limits.

2. Companies Ordinance

The companies ordinance 1984 states the rules and regulation for distribution of the profits to the shareholders. The dividend can be paid out of revenue profit. The directors must follow the rules of companies for distributing profits. They cannot violate the law.

3. Accountancy Principle

The accountancy principles must be followed for calculating the divisible profits. The going concern, consistency, conservation matching concepts is applied. These principles must be applied other wise the reliable result cannot be expected from the accounting books and records.

4. Legal Decision

The legal decision must be kept in mind which calculating the divisible profits. The court cases relating to auditing must be followed if applicable to the conditions of business. The auditor must know the decision announced by the courts from time to time.

5. Capital Maintenance

The principles of capital maintenance must be applied. The capital cannot be used to pay dividend. The revenue profits can be utilized for payments of dividend. The capital account must remain intact. It is illegal it the directors pay dividend out of capital during any year.

6. Shareholders Approval

The divisible profits can be used to pay as dividend after approval of shareholders. The annual general meeting is called and the shareholders approve rate recommended by directors. The rate of dividend proposed cannot be increased at all.

7. Capital Profit

The capital profit can be used to pay dividend under certain conditions. The capital profit should be realized. All the assets should be revalued and even then there is surplus. The articles of association allow the distribution of capital profit as dividend. The depreciation on the revalued assets has been recorded in the books of accounts.

8. Directors Proposal

The directors have the right to propose the rate of dividend under certain conditions. The capital profit should be realized. All the assets should be revalued and even then there is surplus. The articles of association allow the distribution of capital profit as dividend. The depreciation on the revalued assets has been recorded in the books of accounts.

9. Capital Loss

The dividend can be paid out of revenue profits even there is capital loss. There is no need to adjust old capital loss before payment of dividends. The current year revenue profit can used to pay dividend. The capital profit must be used to eliminate capital loss finest and then surplus can be used to pay dividend.

10. Depreciation

The dividend can be paid out revenue profits. The depreciation on fixed assets must be charge to profit and loss before declaring revenue profits. In case of manufacturing company it is compulsory to charge depreciation before declaration of profit or dividend.

11. Past Losses

The company may sustain a loss in one year. It can earn profit in the next year. The company may adjust loss of previous year. The remaining profit of current year can be pay dividends. In 1918, Ammonia Soda Co. V Chamberlain case the court decided that under the articles of association the directors can pay dividend out of current year profit with out adjustment past losses.

12. Transfer to Reserve

The dividend can be paid of revenue profit remaining after transfer to reserves. The articles of association empower the directors to create at a certain rate. In case of banks and financial institutions it is obligatory to set up statutory reserves.

13. Secret Reserves

Management creates the secret reserves by various techniques. The financial institutions need such reserves to develop the confidence of customers and owners. The reserves can be created and used to pay dividend if allowed under the articles. The misuse of such reserves must not be allowed.

14. Undistributed Profit

The directors for declaring dividend can use undistributed profit or profit and loss appropriation balance. It is revenue of the previous years. It is a right of the directors to used such profit for payment of dividend at the end of the year.

15. Profit Prior to Incorporation

The profit prior to incorporation is a capital profit. It cannot be used for payment of dividend. It is a profit earned before the registration of the company. It can be used to write off capital loss or issue of bonus share by the company management.

16. Asset Revaluation

The management can revalue the assets. The surplus on revaluation of assets can be started on liability side of balance sheet. It can be used after realization. The assets may be sold and profit may be realized.

17. Solvency of Company

The solvency of the business is very important than payment of dividend. The management must determine cash needs of the company. If cash is surplus than business requirements then dividend then can be paid is cash. In cash of storage of funds dividend should not be paid in cash.

18. Creditors Protection

It is a principle of divisible profits that dividend must be paid out of revenue profits. The correct calculation is essential for all who depend upon business. The overstatement can disturb one section of investors while understatement can upset another group.

Importance of Correct Profit

1. True Disclosure

The accounting principle requires true disclosure of profit. The purpose of audit is also same. The auditor can form and opinion of the financial statement when true disclosure is there. The true disclosure may lead to show correct profits.

2. Consistency

The importance of correct profit is felt to settle the dispute among various sections of society. The owners need high profits. The debentures holders demand low profits. The principle of consistency can solve the problem by declaring true and correct profit instead of high or low profits for the year.

3. Follow Law

The calculation of correct profit is essential for the business. The calculation of profit depends upon law. When the law is followed there is true profit available for the shareholders. The memorandum, articles of association and companies ordinance must be followed to arrive at correct profit.

4. Protect Creditors

The calculation of true profit is necessary for protection of creditors. The true profit does not reduce the value of assets. The creditors can collect their amount of loan and interest in goods and services.

5. Correct Valuation

The fair value of assets and liabilities is recorded. The correct valuation is desirable for other parties who want to buy such business. The admission of new partner is possible. The amalgamation and merger can take place on the basis of correct valuation of business concern.

6. Stable Share Prices

The benefit of correct profit is available in the shape of stable prices. The investigators in shares can depend on the policies of the company. The management can attract large funds for expansion of business activities. The auditors must try to calculate true profit every year.

7. Manager Remuneration

The benefit of correct profit is available in the shape of true remuneration of management. The manager's commission may be based on profits. The correct profit can pay correct commission to the managers. They can review their progress through their remuneration received.

8. No Undue Favour

The correct profit is useful for all sections of society. There is conflicting interest of shareholders manager, creditors, lenders, investigators and debenture holders. The correct profit favours all parties according to their interest in business.

9. No Dividend Out of Anticipated Profit

The anticipated profit cannot be used for dividends. The profit means profit realized. The unrealized profits are excluded for calculation of correct profit. The shareholders can be allowed dividends out of true realized profits only.

Secret Reserves

A secret reserve is a reserve that is created but not started in the balance sheet. There are various ways secret reserves. The banks, insurance companies and other financial institutions want to win public confidence for their successful working. These business concerns can create secret reserves. It is a technique to show poor financial position to rivals and in case of need such reserves are available to meet crisis. There are merits and demerits of such reserves. The auditor can examine the existence of such a situation. The amount may not be high. The director's intention may be good. The auditor may not disclose such reserves in the audit report. When the amount is high and directors misuse such reserves the auditor must inform the shareholders through his report.

How Secret Reserves is Created

1. Under Valuation of Fixed Assets

The management can create secret reserves by under valuation of fixed assets. In fact the value of fixed assets is much higher but it started at less value. The reserves of the same amount are created. There reserves do not appear in balance sheet.

2. Eliminating Fixed Assets

The management may decide to eliminate any fixed asset. In preparing balance sheet such assets are not stated. The value fixed assets can be used to create secret reserve of the same amount. As the reserves are secret there is no need to show it.

3. Under Valuation of Current Assets

The current assets may be recorded in balance sheet at less value. In this way under valuation of current assets helps the management to conceal profits and reserves from liabilities. The management can be such reserves in times of financial needs.

4. Excess Provision For Bad Debts

The excess provision for bad debts means decrease in the value of debtors below the real value. Stating excess provision for bad and doubtful debts creates the secret reserves. It is only possible when management is selling goods on credit.

5. Charging Capital Expenditure to Revenue

The management can play trick for creating secret reserves. The capital expenditure can be treated as revenue. The profits will be understated. The secret reserves are created to meet the demand of the business management.

6. Overstating Liabilities

The management can over state the value of any liability. This action leads to creation of secret reserves. The profit and reserves are reduced by equal amount.

7. Grouping Dissimilar Items

The different items appearing on liability side may be grouped. The creditors, reserves and provisions may be stated under the heading Sunday creditors and other credit balance.

8. Contingent Liabilities

The management can show contingent liability as actual liability in order to create secret reserves. In fact contingent liability is stated as footnote. But its inclusion in balance sheet met the objective of the management.

9. Including Fictitious Liabilities

The management can show fictitious liabilities as actual liabilities. In this way the reserves and profits can be eliminated for the same amount. The secret reserves are creating in order to obtain certain objectives.

10. Showing Good Will At Nominal Value

The goods will have high value. It may state at nominal value. The secret reserve is created equal to the difference between actual value and nominal value. The directors can create secret in order to meet business objectives.

Advantages of Secret Reserves

1. Increase Working Capital

The purpose of creating secret reserves may be increasing working capital. The shortage of working capital may be lead to failure of business. But use of secret reserves help to improve the financial strength in order to make the business successful.

2. Dividend Equalization

It is a benefit of secret reserve that dividend can be paid at equal rate. When there is sufficient profit there is no need to use secret reserve. In case of low profit or loss the secret reserves can be used to pay dividend. Thus fluctuating profit cannot affect dividend rate.

3. Face Competition

The benefit of secret reserves is available to the management. It can face competition in the market. In order to eliminate or shrink the size other business concern it can become loss leader. The use of secret reserves is helpful to remain in market for long period.

4. Keep Rivals Away

The benefit of secret reserves is that management can keep rival away. The financial position does not look attractive. The new entrants are discouraged. They decide not to enter the field.

5. Meet Financial Exists

The benefit of secret reserves is that management can meet financial crisis in case of emergency. The loan facility may not be available but such reserves are useful for meeting crisis.

6. Win Public Confidence

The management is in a position to win the public confidence. The equal rate of dividend provides confidence to the shareholders. The general public is happy over the reserves.

7. Low Profit Years

The management can use secret reserves in low profit years. Due to poor business activities there may be no profit. Such reserves helps the management to follow the same policies of dividend.
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