Financial Statements of Companies and Buyback — Practice

Question 1

A shipbuilding company has an operating cycle of two years. At 31 March it holds inventories it expects to consume in eighteen months and receivables it expects to collect in twenty months. Its accountant classifies both as non-current because they exceed twelve months. Advise.

Accepted Answer

Both are current assets and the accountant has applied the wrong limb of the test. Schedule III provides that an asset is classified as current if it satisfies any one of four criteria, the first of which is that it is expected to be realised in, or is intended for sale or consumption in, the company's normal operating cycle. The twelve-month criterion is a separate and alternative limb, not an overriding cap, so an asset that falls within the operating cycle is current however long that cycle is. The operating cycle is defined as the time between the acquisition of assets for processing and their realisation in cash or cash equivalents, and it is only where the cycle cannot be identified that it is assumed to be twelve months. This company has an identifiable cycle of two years, so inventories to be consumed in eighteen months and receivables to be collected in twenty months are both realised within the normal operating cycle and are both current. The error is a common one because most companies do have cycles shorter than a year, which makes the twelve-month limb the operative one in ordinary cases and encourages candidates to treat it as the rule rather than as one of four alternatives.

Question 2

A company has a general reserve of ₹60 lakh, a securities premium of ₹25 lakh and a debit balance in the profit and loss account of ₹110 lakh. Show how Reserves and Surplus is presented, and state the rule where Schedule III and an Accounting Standard conflict.

Accepted Answer

Schedule III requires a debit balance of profit and loss to be shown as a negative figure under the head Surplus, and the balance of Reserves and Surplus to be shown after adjusting that negative balance, even where the resulting figure is itself negative. So Reserves and Surplus is presented as: Securities Premium Reserve 25, General Reserve 60, and Surplus, being the balance in the statement of profit and loss, shown as minus 110, giving a total of minus 25 lakh, which is disclosed as a negative figure under Reserves and Surplus on the Equity and Liabilities side. It is not shown on the assets side as a miscellaneous expenditure or profit and loss debit balance, which was the older practice and is no longer permitted. The presentation is more informative because it shows the reader at a glance that accumulated losses have eliminated the company's reserves entirely. As to the hierarchy, Schedule III itself provides that where any Accounting Standard requires a treatment or disclosure different from that provided in the Schedule, the requirements of the Accounting Standard prevail, and the Schedule stands amended to that extent.

Question 3

Explain why managerial remuneration is computed on net profits under section 198 rather than on the profit reported in the accounts, and state four credits that are not included and three deductions that are not to be made.

Accepted Answer

Reported profit is not a stable base for a statutory percentage. It can be moved by accounting choices such as depreciation method and provisioning policy, and it includes items that are not earnings from operating the business, so a percentage of it would sometimes reward managers for capital gains they did not generate and sometimes penalise them for accounting conservatism. Section 198 therefore prescribes its own computation, which strips out capital items on both sides and produces a figure closer to sustainable operating profit. Credits not to be included are premiums on shares or debentures; profits on the sale of forfeited shares; profits of a capital nature including profits from the sale of the undertaking; and profits from the sale of immovable property or fixed assets of a capital nature, unless the business of the company consists in buying and selling such property or assets, in which case only the excess of sale proceeds over written down value up to original cost is included. Deductions not to be made are income tax and super-tax payable by the company; any compensation or damages paid voluntarily rather than under legal liability; and losses of a capital nature, including loss on the sale of the undertaking or of immovable property or fixed assets of a capital nature. Depreciation is deducted, but only to the extent specified in section 123.

Question 4

A public company has net profits under section 198 of ₹800 lakh. It has two whole-time directors and four non-executive directors. Compute the maximum remuneration payable without a special resolution, and state the position where a company has inadequate profits.

Accepted Answer

Section 197 imposes an overall ceiling of eleven per cent of net profits computed under section 198 for all directors and managerial personnel taken together, that is 88 lakh. Within that overall ceiling there are internal limits. Where there is more than one managing director, whole-time director or manager, the aggregate payable to all of them together must not exceed ten per cent of net profits, that is 80 lakh for the two whole-time directors. Where there is a managing or whole-time director or manager, the remuneration payable to directors who are neither managing nor whole-time must not exceed one per cent of net profits, that is 8 lakh for the four non-executive directors between them; had there been no managing or whole-time director, that limit would have been three per cent. The internal limits total 88 lakh, consistent with the overall ceiling. Remuneration in excess of any of these limits requires approval by a special resolution of the members. Where a company has no profits or inadequate profits, it may pay remuneration in accordance with the provisions of Schedule V, which sets slab limits by effective capital, or in excess of those limits with the approval of the members by special resolution.

Question 5

A company has inadequate profits this year and wishes to declare dividend out of accumulated free reserves. Paid-up capital is ₹500 lakh and free reserves ₹400 lakh. Dividend rates in the three preceding years were 12%, 10% and 8%. State the conditions and compute the constraints.

Accepted Answer

Dividend may be declared out of accumulated profits transferred to reserves in a year of inadequate profits, subject to the conditions in the Companies (Declaration and Payment of Dividend) Rules, of which there are four. First, the rate of dividend declared must not exceed the average of the rates at which dividend was declared in the three immediately preceding years, that is the average of 12, 10 and 8, which is 10 per cent; so the rate is capped at 10 per cent, giving a maximum of 50 lakh on paid-up capital of 500 lakh. Second, the total amount to be drawn from accumulated profits must not exceed one-tenth of the sum of paid-up share capital and free reserves as appearing in the latest audited financial statement, that is one-tenth of 900 lakh, which is 90 lakh; this test is not binding here since the rate cap already limits the dividend to 50 lakh. Third, the amount so drawn must first be used to set off the losses incurred in the financial year in which the dividend is declared, before any dividend in respect of equity shares is declared. Fourth, the balance of reserves after such withdrawal must not fall below fifteen per cent of the paid-up share capital as appearing in the latest audited financial statement, that is 75 lakh; reserves of 400 less 50 leaves 350 lakh, comfortably above the floor. The binding constraint is therefore the rate cap, and the maximum dividend is 50 lakh.

Question 6

A candidate states that a company must transfer a prescribed percentage of profits to reserves before declaring dividend. Comment, and state what must be provided for before dividend is declared.

Accepted Answer

The statement describes the position under the Companies Act, 1956 and is no longer correct. Under the Companies Act, 2013 the transfer to reserves before declaring dividend is voluntary: a company may, before the declaration of any dividend in any financial year, transfer such percentage of its profits for that financial year as it may consider appropriate to the reserves of the company. There is no prescribed minimum, and the earlier scheme requiring a graduated transfer according to the rate of dividend proposed has been removed. This is a point on which older study material and a good deal of online commentary remain wrong, so it is worth being definite about. What is mandatory is depreciation: dividend may be declared out of the profits of the company for the year arrived at after providing for depreciation in accordance with section 123, or out of the profits of any previous financial years arrived at after providing for depreciation and remaining undistributed, or out of both. Dividend may also be declared out of money provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government.

Question 7

State the timeline for dealing with dividend that remains unpaid or unclaimed, and what ultimately happens to the money and to the underlying shares.

Accepted Answer

Dividend must be paid within thirty days of its declaration. Where it has been declared but has not been paid or claimed within that period, the company must, within seven days of the expiry of the thirty days, transfer the total amount that remains unpaid or unclaimed to a special account opened for that purpose in a scheduled bank, called the Unpaid Dividend Account. The company must within ninety days of making that transfer prepare a statement of the names, last known addresses and unpaid dividend of the persons entitled and place it on its website. Any amount in the Unpaid Dividend Account that remains unpaid or unclaimed for a period of seven years from the date of the transfer must then be transferred to the Investor Education and Protection Fund established under the Act, together with a statement of the details of the transfer. Critically, the shares in respect of which the dividend has remained unpaid or unclaimed for seven consecutive years are also transferred to the Fund, in the name of the Fund, which is the provision shareholders most often overlook. A claimant may apply to the Fund for a refund of the amount and for the transfer of the shares back to them.

Question 8

A company has paid-up equity capital of ₹400 lakh (shares of ₹10), free reserves of ₹700 lakh and securities premium of ₹100 lakh. Total debt after the proposed buyback would be ₹1,800 lakh. It proposes to buy back 12 lakh shares at ₹40. Test the proposal against every limit in section 68 and state the maximum permissible buyback.

Accepted Answer

Apply each test in turn. Test one, the aggregate limit: the buyback must not exceed twenty-five per cent of the aggregate of paid-up capital and free reserves. Securities premium is a free reserve for this purpose only where the question so indicates; taking paid-up capital of 400 plus free reserves of 700 plus securities premium of 100, that is 1,200 lakh, twenty-five per cent is 300 lakh, and the proposal at 12 lakh shares times 40 is 480 lakh, which fails. Test two, the equity limit: the buyback of equity shares in any financial year must not exceed twenty-five per cent of the paid-up equity capital in that financial year, that is twenty-five per cent of 400 lakh, being 100 lakh of nominal value, which at 10 per share is 10 lakh shares; the proposal of 12 lakh shares fails this too. Test three, the debt-equity test: after buyback, the aggregate of secured and unsecured debts must not be more than twice the paid-up capital and free reserves. After buying back 10 lakh shares at 40, that is 400 lakh, capital falls to 300 and reserves absorb the 300 lakh premium, leaving capital plus free reserves of 400 plus 700 plus 100 less 400, that is 800 lakh; twice that is 1,600 lakh, and debt of 1,800 lakh exceeds it, so the buyback must be reduced further until post-buyback funds support the debt. The binding constraint is therefore the debt-equity test, and the proposal as framed cannot proceed on any of the three.

Question 9

Explain from first principles why a Capital Redemption Reserve must be created on a buyback out of free reserves, why no such transfer is required to the extent the buyback is funded from a fresh issue, and what the reserve may be used for.

Accepted Answer

The purpose is capital maintenance. A company's share capital is the fund on which creditors rely, since limited liability means they have recourse to the company's assets and not to its members, and company law therefore surrounds capital with restrictions on its return. A buyback returns capital, and if it is funded out of free reserves the damage is done twice over: the share capital falls by the nominal value bought back, and the distributable reserves fall by the amount paid. Without a corrective, the reduction in share capital would simply free an equivalent sum of reserves for future distribution, so the total of capital plus undistributable reserves would shrink by more than the cash paid out. Section 68 therefore requires that where a company purchases its own shares out of free reserves or the securities premium account, a sum equal to the nominal value of the shares so purchased is transferred to the Capital Redemption Reserve Account, and the fact is disclosed in the balance sheet. That transfer locks away an amount equal to the capital extinguished, keeping the creditors' cushion intact. Where the buyback is funded out of the proceeds of a fresh issue of shares, no transfer is required to that extent, because the capital has been replaced rather than reduced and the cushion never fell. The Capital Redemption Reserve may be applied only in paying up unissued shares of the company to be issued to members as fully paid bonus shares.

Question 10

A company buys back 5 lakh equity shares of ₹10 each at ₹28, funded entirely from free reserves. Its securities premium account stands at ₹40 lakh. Pass the journal entries.

Accepted Answer

The total consideration is 5 lakh shares at 28, that is 140 lakh, of which nominal value is 50 lakh and premium payable is 90 lakh. First, the amount due to shareholders is recognised: Equity Share Capital A/c is debited with the nominal value of 50 lakh; the premium of 90 lakh is debited, applied first against the Securities Premium A/c to the extent available, that is 40 lakh, with the balance of 50 lakh debited to free reserves such as the General Reserve, since the premium payable on buyback may be met from securities premium and from free reserves; and Equity Shares Buyback A/c is credited with 140 lakh. Second, payment is made: Equity Shares Buyback A/c is debited with 140 lakh and Bank A/c is credited with 140 lakh. Third, the capital maintenance transfer is made: because the buyback was funded out of free reserves and securities premium rather than out of a fresh issue, a sum equal to the nominal value of the shares bought back must be transferred to the Capital Redemption Reserve, so free reserves are debited with 50 lakh and Capital Redemption Reserve A/c is credited with 50 lakh. The shares bought back must be physically destroyed within seven days of the last date of completion of the buyback.

Question 11

State the sources out of which a buyback may be made under section 68(1) and the single prohibition attached to them. Explain the reasoning behind the prohibition.

Accepted Answer

A company may purchase its own shares or other specified securities out of three sources only: its free reserves; the securities premium account; and the proceeds of the issue of any shares or other specified securities. The prohibition is that no buyback may be made out of the proceeds of an earlier issue of the same kind of shares or the same kind of other specified securities. So equity may not be bought back out of the proceeds of an earlier equity issue, though it may be bought back out of the proceeds of a preference share or debenture issue. The reasoning is that the transaction would otherwise be circular and would achieve nothing that the conditions are designed to permit. A buyback is meant either to return genuine surplus to shareholders or to change the capital structure; issuing equity to raise cash and then using that cash to buy equity back does neither, since the company ends where it began except for the transaction costs and a redistribution among shareholders. Worse, it would allow a company to present a buyback as a return of surplus when in fact the money came from the shareholders themselves days earlier, which would mislead the market about the company's cash generation and defeat the signalling that makes a genuine buyback informative.

Question 12

State the authorisation required for a buyback, the time limits that apply before, during and after it, and the restriction on further issues.

Accepted Answer

Authorisation runs at two levels. The buyback must be authorised by the articles of association, and beyond that a board resolution suffices where the buyback is ten per cent or less of the total paid-up equity capital and free reserves of the company, while anything above that threshold requires a special resolution passed at a general meeting. Three time limits then apply. Before: no offer of buyback may be made within a period of one year from the date of the closure of the preceding offer of buyback, which prevents a company from returning capital continuously in successive tranches. During: every buyback must be completed within one year from the date of passing of the special resolution or the board resolution as the case may be. After: the shares or other specified securities bought back must be physically destroyed within seven days of the last date of completion of the buyback, so they cannot be reissued. Finally, a company which has completed a buyback may not make a further issue of the same kind of shares or other securities within a period of six months, except by way of a bonus issue or in discharge of subsisting obligations such as the conversion of warrants, stock option schemes, sweat equity, or the conversion of preference shares or debentures into equity shares.

Question 13

Give three reasons a company might prefer a buyback to a dividend, and explain how each connects to a condition in section 68.

Accepted Answer

First, a company holding surplus cash that it cannot invest at its cost of capital destroys value by holding it, and returning the surplus raises earnings per share and return on equity. A buyback does this more flexibly than a dividend because it creates no expectation of recurrence, whereas a dividend once raised is difficult to cut without signalling distress. This connects to the requirement that the buyback be funded only from free reserves, securities premium or fresh issue proceeds, since the premise is that genuine surplus exists. Second, a buyback can correct an over-capitalised structure by moving the debt-equity ratio towards its optimum, and this is precisely what the debt-equity condition polices from the other direction: the post-buyback ratio of debts to paid-up capital and free reserves must not exceed two to one, so the company may improve its structure but may not gear itself dangerously in the process. Third, a buyback signals management's view that the shares are undervalued, in a way a dividend cannot, because management is committing the company's own money at the current price. The prohibition on funding a buyback from the proceeds of an earlier issue of the same kind of securities protects the integrity of that signal, since a company recycling freshly raised equity is signalling nothing at all.

Question 14

Set out the main heads of the Schedule III balance sheet in the prescribed order on both sides, and explain why share application money pending allotment sits where it does.

Accepted Answer

On the Equity and Liabilities side, in order: Shareholders' funds, comprising share capital, reserves and surplus, and money received against share warrants; Share application money pending allotment; Non-current liabilities, comprising long-term borrowings, deferred tax liabilities net, other long-term liabilities and long-term provisions; and Current liabilities, comprising short-term borrowings, trade payables, other current liabilities and short-term provisions. On the Assets side, in order: Non-current assets, comprising property, plant and equipment and intangible assets split into tangible assets, intangible assets, capital work-in-progress and intangible assets under development, then non-current investments, deferred tax assets net, long-term loans and advances and other non-current assets; and Current assets, comprising current investments, inventories, trade receivables, cash and cash equivalents, short-term loans and advances and other current assets. Share application money pending allotment occupies its own line between shareholders' funds and non-current liabilities because it is neither. It is not yet share capital, since no shares have been allotted and the applicants are not yet members; and it is not straightforwardly a liability either, since the company's expectation is to allot rather than refund. Placing it between the two, on its own, tells the reader exactly that.

Question 15

A company has paid-up equity capital of ₹600 lakh in shares of ₹10, free reserves of ₹900 lakh and post-buyback debt of ₹2,000 lakh. Compute the maximum number of shares it may buy back at ₹50 per share, applying every test.

Accepted Answer

Test the three constraints and take the lowest. Test one, the aggregate limit: twenty-five per cent of paid-up capital plus free reserves, that is twenty-five per cent of 1,500 lakh, which is 375 lakh of consideration; at 50 per share this permits 7.5 lakh shares. Test two, the equity limit: twenty-five per cent of paid-up equity capital, that is twenty-five per cent of 600 lakh, which is 150 lakh of nominal value; at 10 per share this permits 15 lakh shares. Test three, the debt-equity test: after buyback, debt of 2,000 lakh must not exceed twice paid-up capital plus free reserves, so post-buyback funds must be at least 1,000 lakh. If n lakh shares are bought back at 50, the total funds reduce by 50n, from 1,500 lakh, so 1,500 less 50n must be at least 1,000, giving 50n not more than 500 and n not more than 10 lakh shares. The three tests permit 7.5, 15 and 10 lakh shares respectively, and all must be satisfied simultaneously, so the maximum is the lowest, that is 7.5 lakh shares for a total consideration of 375 lakh. Note that the binding constraint differs from problem to problem, which is why all three must be computed rather than the one that looks likeliest.

Practice — Financial Statements of Companies and Buyback

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