Financial Statements of Companies and Buyback

Weightage: Chapters 11 and 12 of ICAI's Paper 1 syllabus, together roughly 14 marks. Format-driven work where the schedule itself is separately marked, which makes it drillable in a way the standards are not.

Why the format is prescribed

A company's financial statements are read by people who did not prepare them and often hold no direct relationship with the company at all. Schedule III to the Companies Act, 2013 prescribes their form so that any reader can find the same information in the same place in any company's accounts.

That is worth taking seriously as a candidate, because it explains the two things about Schedule III that otherwise look arbitrary: the rigid ordering, and the insistence on the current-year and previous-year columns. Both exist to make comparison possible without re-reading.

Where Schedule III conflicts with an Accounting Standard, the Accounting Standard prevails. Schedule III says so itself, and it is examined.

The Balance Sheet under Schedule III

The vertical format runs in a fixed sequence.

Equity and Liabilities

Shareholders' funds comprise share capital, reserves and surplus, and money received against share warrants.

Share application money pending allotment stands as its own line between shareholders' funds and non-current liabilities, because it is neither yet.

Non-current liabilities comprise long-term borrowings, deferred tax liabilities (net), other long-term liabilities, and long-term provisions.

Current liabilities comprise short-term borrowings, trade payables, other current liabilities, and short-term provisions.

Assets

Non-current assets comprise property, plant and equipment and intangible assets — split into tangible assets, intangible assets, capital work-in-progress and intangible assets under development — followed by non-current investments, deferred tax assets (net), long-term loans and advances, and other non-current assets.

Current assets comprise current investments, inventories, trade receivables, cash and cash equivalents, short-term loans and advances, and other current assets.

The current and non-current distinction

An asset is current if it satisfies any of: it is expected to be realised in, or is intended for sale or consumption in, the company's normal operating cycle; it is held primarily for the purpose of being traded; it is expected to be realised within twelve months after the reporting date; or it is cash or a cash equivalent unless restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date.

A liability is current if it satisfies any of: it is expected to be settled in the company's normal operating cycle; it is held primarily for the purpose of being traded; it is due to be settled within twelve months after the reporting date; or the company does not have an unconditional right to defer settlement for at least twelve months after the reporting date.

The operating cycle is the time between the acquisition of assets for processing and their realisation in cash or cash equivalents. Where it cannot be identified, it is assumed to be twelve months. This is the definition that catches candidates out: a company with a two-year operating cycle, such as a shipbuilder, classifies as current the receivables it expects to collect in eighteen months.

Reserves and surplus

Presented as a classified total, and negative balances matter. Where a company has a debit balance of profit and loss, it is shown as a negative figure under the head Surplus, and the balance of Reserves and Surplus is shown after adjusting the negative balance — even if the resulting figure is negative.

Managerial remuneration

Governed by section 197 of the Companies Act, 2013 and computed on net profits determined under section 198, which is not the same as the profit reported in the accounts.

The overall ceiling for a public company is eleven per cent of net profits for all directors and managerial personnel taken together. Within that:

• five per cent to any one managing director, whole-time director or manager;
• ten per cent to all of them together if there is more than one;
• one per cent to directors who are neither managing nor whole-time, where there is a managing or whole-time director or manager;
• three per cent to such directors in any other case.

Remuneration in excess of these limits requires approval by a special resolution of the members.

Where a company has inadequate profits or no profits, remuneration may be paid in accordance with Schedule V, or in excess of it with a special resolution.

Section 198 computation

The reason section 198 exists is that reported profit is not a stable base for a statutory percentage: it can be moved by accounting choices and it includes items that are not operating earnings.

Credits to be included are the ordinary trading profits.

Credits not to be included are premiums on shares or debentures, profits on sale of forfeited shares, profits of a capital nature including profits from the sale of the undertaking, and profits from the sale of any 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 the excess of the sale proceeds over the written down value is included only up to original cost.

Deductions to be made include all the usual working charges, directors' remuneration, bonus or commission paid to staff, tax on excess or abnormal profits, interest on debentures and on loans, repairs, outgoings inclusive of contributions, depreciation to the extent specified in section 123, prior period losses, and legal liability for compensation or damages.

Deductions not to be made are income tax and super-tax payable by the company, any compensation or damages paid voluntarily, and loss of a capital nature including loss on sale of the undertaking or of immovable property or fixed assets of a capital nature.

Divisible profits and dividend

Dividend may be declared out of the profits of the company for the year after providing for depreciation, out of the profits of previous years remaining undistributed after providing for depreciation, or out of both. It may also be declared out of money provided by the Central or a State Government for the payment of dividend in pursuance of a guarantee.

Depreciation must be provided before dividend is declared, and this is not a matter of discretion.

Transfer to reserves is voluntary under the Companies Act, 2013. A company may, before declaring dividend, transfer such percentage of its profits as it considers appropriate to its reserves. The compulsory transfer that existed under the earlier Act is gone, which is a point older material still gets wrong.

Declaring dividend out of free reserves in a year of inadequate profits is permitted subject to conditions in the Companies (Declaration and Payment of Dividend) Rules: the rate must not exceed the average of the rates at which dividend was declared in the three immediately preceding years; the total amount drawn from accumulated profits must not exceed one-tenth of the sum of paid-up share capital and free reserves; the amount so drawn must first be used to set off losses incurred in the financial year; and the balance of reserves after such withdrawal must not fall below fifteen per cent of paid-up share capital.

Unpaid dividend must be transferred to a special account within seven days of the expiry of the thirty days allowed for payment. Amounts remaining unpaid or unclaimed for seven years are transferred to the Investor Education and Protection Fund, along with the underlying shares.

Buyback of securities

Why a company would buy back its own shares

Three reasons recur, and stating them makes the conditions intelligible.

A company holding surplus cash with no investment opportunity yielding its cost of capital destroys value by holding it. Returning it raises earnings per share and return on equity. A buyback is a more flexible way of doing that than a dividend, because it does not create an expectation of recurrence.

A buyback can correct an over-capitalised structure, moving the debt-equity ratio towards optimum.

And it signals management's view that the shares are undervalued, which a dividend does not.

The constraint the conditions exist to enforce

A buyback returns capital to shareholders, and capital is the fund on which creditors rely. Every condition in section 68 is a variation on one requirement: the creditors' cushion must be preserved. That is why the buyback must be funded from distributable sources, why an equivalent amount must be locked into an undistributable reserve, and why the debt-equity ratio is capped.

Sources — section 68(1)

A company may purchase its own shares or other specified securities only out of:

• its free reserves;
• the securities premium account;
• the proceeds of the issue of any shares or other specified securities.

But no buyback may be made out of the proceeds of an earlier issue of the same kind of shares or same kind of other specified securities. Buying back equity out of the proceeds of a fresh equity issue would be circular and would return nothing.

Conditions — section 68(2)

Authorisation. The buyback must be authorised by the articles. A board resolution suffices where the buyback is ten per cent or less of the total paid-up equity capital and free reserves; beyond that, a special resolution in general meeting is required.

The 25 per cent limits. The buyback must not exceed twenty-five per cent of the aggregate of paid-up capital and free reserves. In addition, in respect of the buyback of equity shares in any financial year, it must not exceed twenty-five per cent of the paid-up equity capital in that financial year. The two tests are different in their bases and both must be satisfied — the first on capital plus free reserves and applied to the whole buyback, the second on paid-up equity capital alone and applied to equity in the year.

The debt-equity test. The ratio of the aggregate of secured and unsecured debts owed by the company after buyback must not be more than twice the paid-up capital and its free reserves. So post-buyback debt must not exceed twice post-buyback equity.

Fully paid. All the shares or other specified securities for buyback must be fully paid up.

Timing. 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.

Completion. Every buyback must be completed within one year from the date of the passing of the special resolution or the board resolution, as the case may be.

Extinguishment. The shares bought back must be physically destroyed within seven days of the last date of completion of the buyback.

Further issue restriction. A company that has completed a buyback may not make a further issue of the same kind of shares within a period of six months, except by way of bonus issue, or the conversion of warrants, stock option schemes, sweat equity, or the conversion of preference shares or debentures into equity.

Capital Redemption Reserve

Where a company purchases its own shares out of free reserves or securities premium, a sum equal to the nominal value of the shares so purchased must be transferred to the Capital Redemption Reserve Account, and the fact must be disclosed in the balance sheet.

The reason repays a moment's thought, because it is the clearest illustration of capital maintenance in the syllabus. Buying back shares out of free reserves reduces both the share capital and the distributable reserves. Without the CRR transfer, the reduction in share capital would simply release an equivalent amount of reserves for distribution, and the creditors' cushion would fall twice over. The CRR locks away an amount equal to the nominal value bought back, so the total of capital plus undistributable reserves is unchanged.

The CRR may be applied only in paying up unissued shares to be issued as fully paid bonus shares.

The entries

On buyback out of free reserves, at a price above nominal value:

• Equity Share Capital A/c debited with nominal value;
• Premium payable on buyback debited to Securities Premium Account, or to free reserves where the premium exceeds the securities premium available;
• credited to Equity Shares Buyback A/c, which is then settled by payment to shareholders;
• Free Reserves or Securities Premium debited and Capital Redemption Reserve credited with the nominal value bought back.

Where the buyback is funded out of the proceeds of a fresh issue, no CRR transfer is required to the extent of the fresh issue, because the capital has been replaced rather than reduced.