Tag: Dividend Policy

Schedule II prescribes the useful lives of assets, based on which companies calculate depreciation. Unlike the earlier Companies Act, 1956, which specified rates, the 2013 Act recommends useful life, and companies can use any depreciation method (Straight Line or Written Down Value) based on these lives.

Useful Life and Depreciation under Schedule II

The depreciation is computed on the basis of:

• Asset’s useful life, not pre-defined rate.

• Residual value (usually not more than 5% of the original cost).

• Depreciation method (SLM or WDV) chosen by the company.

Below is a table of commonly used asset categories and their useful lives as per Schedule II:

💡 Key Notes:

• If a company uses a useful life different from Schedule II, it must disclose the justification in its financial statements.

• Residual value should generally not exceed 5% of the original cost of the asset.

• Companies can follow Straight Line Method (SLM) or Written Down Value Method (WDV).

• Depreciation is charged from the date of addition and up to the date of disposal of the asset.

Example: Depreciation Calculation (SLM)

Asset: Plant & Machinery

Cost: ₹10,00,000

Useful life: 15 years

Residual value: ₹50,000 (5%)

Depreciable amount: ₹10,00,000 – ₹50,000 = ₹9,50,000

Annual Depreciation (SLM): ₹9,50,000 / 15 = ₹63,333.33

Summary

The Pre-incorporation period refers to the time span between the date a business starts operations and the date it is legally incorporated as a company under the Companies Act, 2013. During this period, the company does not exist as a legal entity, but its promoters may begin business activities such as purchasing assets, hiring staff, or entering contracts. Any income earned or expenses incurred in this period are not considered regular business transactions for the company. As a result, profits made are treated as capital profits and transferred to the Capital Reserve, while losses are capital losses. Accurate distinction is vital for legal compliance and correct financial reporting.

Features of Pre-incorporation Periods:

• Period Before Legal Incorporation

The pre-incorporation period refers to the time span before a business is formally registered as a company under the Companies Act, 2013. Although business activities such as negotiations, purchase of assets, and market research may begin during this period, the company itself does not legally exist. As such, it cannot enter into contracts or sue/be sued in its own name. All decisions and operations are usually carried out by the promoters. This period ends the moment the company receives its certificate of incorporation, after which it becomes a separate legal entity.

• Handled by Promoters

During the pre-incorporation period, business activities are undertaken and managed by the promoters of the company. Promoters are individuals or groups who conceptualize the business, arrange capital, acquire assets, negotiate deals, and prepare documents for incorporation. Since the company does not yet exist legally, it cannot make decisions or be held liable. Hence, any contracts or agreements made during this time are technically between third parties and the promoters, not the company. The promoters may later be reimbursed by the company for any expenses incurred once it is incorporated and passes a ratification resolution.

• No Legal Identity of the Company

One of the most important features of the pre-incorporation period is that the company does not yet have a legal identity. This means it cannot enter into contracts, own property, borrow funds, or take any legal action in its name. It has no legal standing until a Certificate of Incorporation is issued by the Registrar of Companies. Any legal obligations or liabilities during this phase are solely borne by the promoters. As a result, care must be taken when undertaking business transactions before incorporation to avoid legal complications.

• Pre-incorporation Profits are Capital Profits

Any profits earned during the pre-incorporation period are treated as capital profits because they are not generated by a legal corporate entity. These profits are usually earned through operations that begin before incorporation, such as sales or services. Since the company was not legally formed, these profits cannot be distributed as dividends. Instead, they are transferred to the Capital Reserve Account. They may be used for writing off preliminary expenses or issuing bonus shares, but not for paying dividends to shareholders. This ensures legal compliance and accurate profit reporting.

• Losses are Treated as Capital Losses

Just as profits before incorporation are treated as capital in nature, losses incurred during the pre-incorporation period are treated as capital losses. These losses may arise from expenses like rent, salaries, or utilities incurred before the company’s legal formation. Since the company was not legally in existence, such losses are not considered operational losses. They are recorded separately in the books and may be adjusted against capital profits or shown as miscellaneous expenditure to be written off later. This accounting treatment ensures that operational results reflect only the company’s legally valid business activities.

• Apportionment of Income and Expenses

To determine pre- and post-incorporation profits or losses, income and expenses must be apportioned between the two periods using a logical basis. This is usually done using time ratio or sales ratio, depending on the nature of the item. For example, rent and salaries are generally apportioned based on time, while sales-related items like commission or advertisement are apportioned based on sales. This distinction helps ensure that only legitimate post-incorporation results are reported in the Profit and Loss Account, while pre-incorporation amounts are adjusted through Capital Reserve or Goodwill.

• Contracts Made Are Not Binding on Company

Contracts made during the pre-incorporation period are not automatically binding on the company after it is incorporated. This is because a company cannot be a party to a contract before it exists legally. However, once incorporated, the company may choose to ratify or accept these contracts through a board resolution. If it does not ratify them, the company cannot be held liable. Promoters remain personally responsible for such agreements unless the company adopts them formally. This feature makes it crucial for promoters to act cautiously when entering into contracts on behalf of a not-yet-formed company.

• Separate Financial Treatment Required

The financial results of the pre-incorporation period must be accounted for separately from post-incorporation results to ensure compliance with legal and financial reporting standards. This involves preparing a separate Profit and Loss Statement for the pre-incorporation period and using proper apportionment methods. Only post-incorporation profits can be used for declaring dividends or other operational expenses. Separating these periods ensures accurate representation of a company’s financial performance and avoids any potential misstatements or misuse of funds. This also helps in audits, tax filings, and decision-making by shareholders and management.

Post-incorporation Periods

The post-incorporation period begins from the date a company is legally registered under the Companies Act, 2013, and continues thereafter. From this date, the company becomes a separate legal entity, capable of owning property, entering contracts, and conducting business in its own name. All income earned and expenses incurred during this period are considered the company’s operational results and are recorded in its Profit and Loss Account. Profits earned during the post-incorporation period can be distributed as dividends to shareholders, subject to compliance with company law. Proper segregation from the pre-incorporation period ensures accurate financial statements, legal validity, and correct determination of taxable and distributable profits.

Features of Post-incorporation Periods:

• Begins from the Date of Incorporation

The post-incorporation period begins on the date the company receives its Certificate of Incorporation from the Registrar of Companies under the Companies Act, 2013. From this date, the company becomes a separate legal entity capable of conducting business in its own name. It can own property, enter into contracts, borrow money, and sue or be sued. All activities and transactions during this period are legally valid and recorded in the company’s books. The post-incorporation period signifies the official commencement of corporate operations and the start of lawful accounting, taxation, and reporting obligations.

• Legal Recognition of the Company

In the post-incorporation period, the company attains full legal status and recognition as a distinct corporate body. It gains rights, responsibilities, and obligations under the Companies Act. This legal status allows it to operate independently of its promoters or shareholders, entering into enforceable contracts, owning assets, and complying with statutory requirements. Unlike the pre-incorporation phase, where promoters act on behalf of the company, in this phase the company acts in its own name. This feature is crucial for establishing credibility with investors, lenders, customers, and regulatory bodies.

• Income and Expenses Are Operating in Nature

All income earned and expenses incurred during the post-incorporation period are considered revenue in nature and form part of the company’s regular business operations. These are recorded in the Profit and Loss Account, and the resulting net profit or loss is used to assess the company’s financial performance. Unlike the capital nature of pre-incorporation profits, post-incorporation profits are available for dividend distribution after meeting statutory requirements. This feature is vital for tracking operational efficiency and managing business strategy based on accurate financial data.

• Eligible for Dividend Declaration

One of the most significant features of the post-incorporation period is that profits earned during this phase can be legally distributed as dividends to shareholders, subject to the availability of free reserves and compliance with Section 123 of the Companies Act, 2013. Dividends can only be paid from profits after tax, and only if all statutory liabilities (such as depreciation, taxes, and reserves) are addressed. This makes the post-incorporation period financially important for investors, as they expect returns based on the company’s performance in this phase.

• Governed by Corporate Laws and SEBI Regulations

During the post-incorporation period, the company is fully subject to various legal and regulatory frameworks, including the Companies Act, 2013, Income Tax Act, SEBI regulations (for listed companies), and other industry-specific laws. The company is required to maintain statutory books, file annual returns, conduct board and general meetings, and adhere to compliance timelines. Non-compliance during this period can lead to penalties, disqualification of directors, or legal action. Therefore, this phase demands proper governance, financial discipline, and adherence to corporate responsibilities.

• Management by Board of Directors

In the post-incorporation period, the Board of Directors assumes full control of the company’s management and decision-making. They are appointed either at incorporation or in the first general meeting and act as agents of the company. Their responsibilities include implementing business policies, approving budgets, declaring dividends, and ensuring legal compliance. Directors are bound by fiduciary duties and must act in the best interests of the company and its shareholders. The transition from promoter-led management (in pre-incorporation) to board-driven governance reflects the company’s formal corporate structure.

• Accounting Books Are Maintained as per Law

From the date of incorporation, companies are legally required to maintain proper books of accounts as per Section 128 of the Companies Act, 2013. These books must reflect true and fair views of the financial position and be maintained at the registered office. Transactions like sales, purchases, payments, and receipts are recorded, and financial statements such as the Balance Sheet and Profit and Loss Account are prepared annually. This feature helps ensure transparency, supports audits, and allows stakeholders to assess the company’s financial health in the post-incorporation period.

• Liabilities and Obligations Are Binding on Company

Unlike the pre-incorporation phase where promoters bear personal liability, liabilities incurred during the post-incorporation period are binding on the company itself. The company, being a separate legal entity, is accountable for its own debts, contractual obligations, and statutory dues. Creditors, employees, and vendors can hold the company liable for non-fulfillment of obligations. This legal accountability ensures operational transparency and builds trust with external stakeholders. It also means that the company can be held accountable in a court of law for any breach or default during its official existence.

Key differences between Pre-incorporation Periods and Post-incorporation Periods

When a company is formed, there is often a gap between the date it starts business operations and the date it is legally incorporated. This period, from when the business begins its operations to the official date of incorporation, is referred to as the “pre-incorporation period”. Any profit or loss that arises during this time is called Profit or Loss Prior to Incorporation.

Such profits or losses are not earned or incurred by a legal company since the company did not exist legally during that period. As a result, the treatment of such profits or losses is different from normal business results. These pre-incorporation profits are considered capital profits and are not available for dividend distribution. Similarly, pre-incorporation losses are treated as capital losses.

This concept arises especially when a business is taken over as a going concern — for example, when promoters take over a partnership firm or an existing business before incorporating the company.

Profit Prior to Incorporation:

Profit prior to incorporation refers to the profit earned by a business between the date of acquisition of a business and the date on which the company is incorporated. Since the company was not a legal entity during this period, any income or expense during this time is not operational in nature for the company. These profits are usually earned from sales or services and are computed by apportioning income and expenses between the pre- and post-incorporation periods using appropriate ratios.

For example, if a company is incorporated on 1st June, but starts operations on 1st April, any income or expense from 1st April to 31st May is considered for pre-incorporation period, while income/expense after 1st June is for the post-incorporation period. The profit prior to incorporation is treated as a capital profit and transferred to Capital Reserve, not Profit and Loss Account.

Concept and Significance:

The concept of profit prior to incorporation is important for maintaining accurate financial reporting and legal compliance. As per company law, only profits earned after incorporation are available for distribution as dividends to shareholders. Hence, profits earned before incorporation cannot be used for that purpose. These profits are instead transferred to the Capital Reserve Account, which is a part of shareholders’ funds but cannot be used for dividend.

The apportionment between pre- and post-incorporation periods ensures that income and expenses are recorded correctly. This also helps in identifying which part of the revenue and expenses are legally attributable to the company. For example, salaries paid during the pre-incorporation period are often treated differently from those paid later, since the company wasn’t officially formed and hence, did not employ staff legally during that time.

Basis of Apportionment:

Income and expenses are divided between the pre- and post-incorporation periods using the following bases:

• Time Ratio = Period before incorporation : Period after incorporation

• Sales Ratio = Sales before incorporation : Sales after incorporation

This helps ensure that the Profit and Loss Account reflects only post-incorporation activities, and the pre-incorporation profit is appropriately adjusted in capital accounts.

Accounting Treatment:

• Profit Prior to Incorporation is transferred to Capital Reserve account.

• Loss Prior to Incorporation is treated as a capital loss and is debited to Goodwill Account or shown as a separate item under Miscellaneous Expenditure (to the extent not written off).

Journal Entries:

(a) When Profit Prior to Incorporation is ascertained:

Profit and Loss A/c (Pre-incorporation Dr.)

To Capital Reserve A/c

(b) When Loss Prior to Incorporation is incurred:

Goodwill A/c or Capital Reserve A/c Dr.

To Profit and Loss A/c (Pre-incorporation)

The treatment ensures profits or losses not earned during the legal existence of the company do not distort distributable earnings.

Example with Table:

A business was taken over on 1st April 2024, and the company was incorporated on 1st August 2024. The financial year ends on 31st March 2025. Sales and expenses are as follows:

Sales Ratio = 4,00,000 : 8,00,000 = 1 : 2

Apportionment Table:

Gross Profit – (Rent + Salaries + Selling Exp. for pre-incorp)

= ₹1,33,333 – (₹20,000 + ₹40,000 + ₹26,667) = ₹46,666

→ This is transferred to Capital Reserve.

Initial Subscription of shares refers to the process of offering and receiving applications for shares when a company first issues them to the public. It occurs during the company’s initial public offering (IPO) or any new issue. Investors apply for shares by submitting application forms along with the required application money. If the company receives applications for at least 90% of the issued shares, the subscription is considered successful as per SEBI guidelines. If the subscription falls short, the issue may be canceled, and application money refunded. Initial subscription ensures capital inflow for business operations and helps determine investor interest in the company’s shares.

Reasons of Initial Subscription of Shares:

• To Raise Capital for Business Operations

Companies issue shares initially to raise long-term capital needed to start or expand business operations. This capital may be used for purchasing fixed assets, funding research and development, meeting working capital needs, or paying off debt. Unlike loans, share capital does not require repayment, making it a stable source of finance. The funds raised through initial subscription help the company establish its foundation and gain financial independence. It also improves the company’s credibility among stakeholders. Therefore, initial share subscriptions are a critical step in mobilizing financial resources for sustainable growth and expansion.

• To Distribute Ownership Among Public Investors

Initial subscription allows companies to distribute ownership among a wide base of public investors. By offering shares to the public, a company transitions from private to public ownership. This widens the shareholder base, which increases trust, improves liquidity of shares, and may enhance market reputation. A diversified ownership also brings transparency and better governance due to regulatory compliance. Public participation ensures that the company is not overly dependent on a few promoters or investors, reducing risk. Through initial subscription, companies align their interests with those of the public, creating a mutually beneficial investment environment.

• To Meet Regulatory and Listing Requirements

Initial subscription of shares helps companies meet regulatory and stock exchange listing requirements. Regulatory bodies like SEBI mandate that a minimum percentage of a company’s shares must be held by the public to ensure transparency, fairness, and investor protection. For example, a company must secure at least 90% subscription of its public issue to proceed. Listing on a stock exchange through public subscription improves access to capital markets and enhances the company’s visibility. Compliance with these legal requirements through initial subscription is essential for a company to operate as a public limited entity and access further fundraising options.

Types of Initial Subscription of Shares:

• Public Subscription

Public subscription involves offering shares directly to the general public through a prospectus. It is the most common form of initial subscription, especially during an Initial Public Offering (IPO). Investors apply for shares by submitting application forms along with the required funds. If the issue is fully or oversubscribed, shares are allotted proportionately. This method allows wide participation, increases public trust, and helps the company raise substantial capital. It also enhances liquidity and corporate image. Regulatory approval from bodies like SEBI is required, and disclosures must be made to ensure transparency, making public subscription a heavily monitored process.

• Private Placement

Private placement refers to the offering of shares to a selected group of investors such as institutional investors, high-net-worth individuals (HNIs), or banks, rather than the general public. It is quicker and involves fewer regulatory procedures compared to public subscription. Private placements help companies raise capital efficiently without issuing a full-fledged prospectus. This type is preferred by startups and private companies that wish to avoid the costs and disclosures associated with a public issue. SEBI guidelines restrict the number of subscribers to 200 per financial year, and shares are usually sold at a negotiated price to raise the required funds.

• Rights Issue

A rights issue involves offering additional shares to existing shareholders in proportion to their current holdings. It is a way for companies to raise fresh capital without bringing in new investors. Shareholders receive the “right” to purchase new shares at a discounted price within a specific timeframe. Though not a traditional initial subscription (since the company is already operational), it is sometimes used during a first capital call. It allows loyal shareholders to maintain their ownership percentage and supports the company’s funding needs with minimal dilution. Rights issues are regulated and disclosed publicly, requiring board and shareholder approval.

• Preferential Allotment

Preferential allotment refers to issuing shares to a select group of persons on a preferential basis, typically at a pre-decided price. It includes private equity investors, venture capitalists, or strategic business partners. This method allows the company to quickly raise funds with fewer regulatory formalities compared to a public issue. Though not open to the general public, it is considered a type of initial share subscription when used during early funding stages. SEBI has strict guidelines for pricing, disclosure, and lock-in periods to prevent misuse. It’s especially useful for companies looking for strategic investments or quick capital infusion.

When a company issues shares/debentures to the public, underwriters agree to subscribe to the portion of shares not taken up by the public. This ensures full subscription of the issue.

If the public does not subscribe fully, the underwriter(s) must take up the remaining (unsubscribed) shares. Sometimes, the liability is divided among multiple underwriters, and they may have firm underwriting, i.e., they agree to take up a specific number of shares irrespective of public subscription.

Steps to Prepare the Statement:

1. Total Issue of shares.

2. Less: Marked Applications (applications attributed to specific underwriters).

3. Less: Unmarked Applications (applications not attributed to any underwriter; divide in agreed ratio).

4. Add: Firm Underwriting (shares underwritten on firm basis — always added).

5. Compute Net Liability of each underwriter:

   • Gross Liability – Marked Applications – Share of Unmarked Applications + Firm Underwriting.

Example

Let’s assume a company issues 1,00,000 shares, underwritten as:

• Unmarked applications are divided in the gross liability ratio (A:B:C = 40:35:25).

• Firm underwriting is always added to the final liability, as it’s considered additional commitment.

Bonus Shares are additional shares given to existing shareholders without any extra cost, based on the number of shares they already hold. These are issued by capitalizing a part of the company’s free reserves or securities premium. The issue of bonus shares is governed by Section 63 of the Companies Act, 2013. This section lays down the conditions and sources through which a company may issue bonus shares. Bonus issues help companies in retaining earnings, improving the stock’s liquidity, and signaling strong future prospects. However, they do not increase the company’s net worth but rather restructure it. Since bonus shares affect the capital structure, Companies Act, 2013 imposes specific regulations to ensure that the interests of shareholders and creditors are protected. The Act provides a clear legal framework under which companies can convert reserves into share capital while maintaining transparency and compliance with corporate governance norms.

• Section 63: Conditions for Issue of Bonus Shares

Section 63 of the Companies Act, 2013 is the primary legal provision governing the issue of bonus shares. According to this section, a company may issue fully paid-up bonus shares to its members from: (i) free reserves, (ii) the securities premium account, or (iii) the capital redemption reserve account. However, it must not issue bonus shares by capitalizing revaluation reserves. Also, the issue must be authorized by the company’s articles of association. If not, the articles must be amended before issuing bonus shares. A bonus issue must be recommended by the Board of Directors and approved in a general meeting by the shareholders. Importantly, bonus shares must be fully paid-up and cannot be issued in lieu of dividends. Section 63 also prohibits issuing bonus shares if the company has defaulted in the payment of any dues to its creditors or employees, thereby safeguarding stakeholders’ interests.

• Procedure for Issuing Bonus Shares

The procedure for issuing bonus shares under the Companies Act, 2013 involves several steps. Firstly, the Board of Directors must meet to consider and pass a resolution recommending the bonus issue. This is followed by obtaining shareholder approval through an ordinary resolution in a general meeting. If the company is listed, it must also comply with SEBI guidelines and stock exchange requirements. After approval, the company needs to file Form MGT-14 with the Registrar of Companies (RoC) for the resolution passed. Next, the company must issue a notice to shareholders stating the record date for eligibility. Bonus shares must be credited to shareholders within two months from the date of approval. Furthermore, any increase in authorized share capital due to the bonus issue requires prior approval and filing of Form SH-7. This structured procedure ensures legal compliance, transparency, and protection of investors’ rights during the bonus share issuance process.

• Prohibitions and Restrictions on Bonus Issue

Section 63 also outlines restrictions to ensure prudent financial practices. A company is prohibited from issuing bonus shares if it has defaulted in the repayment of any deposits, interest thereon, redemption of debentures, or statutory dues of employees. This ensures that companies prioritize their existing financial obligations before distributing reserves as bonus shares. Moreover, bonus shares cannot be issued partially paid — they must be fully paid-up. Another significant restriction is that companies cannot issue bonus shares in lieu of dividend; doing so would violate the spirit of capital restructuring. The Act also mandates that bonus shares must be made available to existing shareholders on a pro-rata basis, maintaining equality among shareholders. These restrictions are important for ensuring that the issue of bonus shares is not misused to manipulate share prices or mislead investors about the financial health of the company.

• Role of the Articles of Association and Board

The Articles of Association (AoA) of a company must authorize the issue of bonus shares. If the AoA do not contain such a provision, they must be amended by passing a special resolution in a general meeting before proceeding with the bonus issue. Once the AoA authorizes it, the Board of Directors plays a crucial role in initiating and recommending the issue. The Board must pass a resolution declaring the source of funds, the ratio of the bonus issue (e.g., 1:2 or 2:5), and the record date. The Board must ensure the company is compliant with all legal, financial, and regulatory obligations. The role of the Board is not only administrative but also fiduciary—they must act in the best interests of the company and its shareholders. Their decisions should reflect transparency, ethical governance, and long-term value creation. All board and shareholder resolutions must be properly documented and filed.

• SEBI Guidelines and Compliance for Listed Companies

For companies listed on a recognized stock exchange in India, issuing bonus shares must also comply with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. These guidelines mandate that the bonus issue must be made from free reserves built from genuine profits or securities premium collected in cash. Listed companies must not convert reserves created by revaluation of assets into bonus shares. They are also required to ensure that there is no pending fully or partly paid-up right issue, nor should the company have defaulted in any financial obligations. SEBI mandates that bonus shares must be credited within 15 days of the record date and that no new bonus issue is announced within one year of a previous bonus or rights issue. Further, proper disclosure through stock exchanges, investor communication, and corporate filings must be maintained. These regulations aim to protect investor confidence and uphold fair trading practices in the securities market.