Under sub-section (3) of the companies Act, 2013 (hereinafter referred to as "The Act"), the expression "Surplus in the profit and loss account" has been used. The sub-section contemplates that the above Surplus can be put to use as one of the silos from which the Board of a company can use for declaration of interim dividend. The above term has not been defined in the Act.
A surplus in the Profit and Loss account is not defined
It is a settled rule of statutory interpretation that where the definition of a word has not been given in the Statute, it must be construed in its popular sense if it is a word of everyday use. Popular sense means that sense with which people conversant with the subject matter with which the Statute dealing with it would attribute to it.(Commissioner of Income Tax,Andhra PradeshvTajMahal Hotel,Secundrabad(1972)(1)SCR 168).
Another presumption that is followed is that where an Act does not define a word used in it, the Legislature must be taken to have used that word in its ordinary, dictionary meaning. (Union of India v Delhi Cloth &General Mills Ltd.(AIR 1963 SC 791).
A surplus in Profit and Loss Account - Its meaning in Accounting Parlance
In Accounting Parlance, the term "Surplus in the profit and loss account "is used to refer to the credit balance in the profit and loss account after providing for dividends, bonuses, provision for taxation, and general reserves. The surplus may also be earmarked for special purposes such as reserves for obsolescence of plant and machinery.
Schedule III to the Act which corresponds to Section 129 of the Act sets out the general instructions for the preparation of the Balance Sheet and Statement of profit and loss of a company refers to "Surplus" as i.e. balance in Statement of Profit and Loss disclosing allocations and appropriations such as dividend, bonus shares and transfer to/from reserves, etc. Debit balance of Statement of Profit and loss shall be shown as a negative figure under the head "Surplus".Similarly the balance of "Reserves and Surplus" after adjusting the negative balance of surplus, if any, shall be shown under the head "Reserves and surplus" even if the resulting figure is in the negative.
Therefore the said Schedule clearly distinguishes between a "Reserve " and a "Surplus", although both are to be disclosed under the head "Reserves and surplus".
The surplus in the profit and loss statement can be explained to represent an amorphous mass of profits that remains undistributed after appropriations have been made for the creation of different reserves including those that are statutory in nature and after providing for dividend and hence it has to be viewed in isolation from a Reserve.
Another connotation to the term "Surplus" in the Accounting arena is that it refers to the amount of retained earnings recorded in an entity’s balance sheet. A surplus is considered good since it implies that there are excess resources available that can be deployed in the future.
Is Surplus in Profit and loss account to be considered as part of "Free Reserves"
Section 2(43) of the Act defines "Free Reserves" as:
"such reserves which as per the latest audited balance sheet of the company are available for distribution as dividend:
Provided that –
(i)any amount representing unrealized gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or
(ii)any change in carrying amount of an asset or of a liability recognized in equity, including surplus in profit and loss account on measurement of the asset or liability at fair value, shall not be treated as free reserves".
Definition of Free Reserves is restrictive
The above definition is a "means" definition and is therefore exhaustive. When a word is defined to "mean" something, the definition is prima facie restrictive. (Vanguard Fire and General Insurance Co.Ltd v Fraser &Ross(AIR 1960 SC 971 on page 975). A "means" definition as provided by the Statute is a "hard and fast" definition and no meaning other than what is put in the definition can be assigned to the same. It is not possible to include within the ambit of such a definition, words, or meanings beyond what has been contemplated in the same.
The definition of "Free Reserves" as reproduced above excludes from consideration any surplus in the Profit and loss Account including the carrying amount of an asset or of a liability if it has been recognized in the Books as a Surplus in the Profit and loss statement.
As has been explained above, "Surplus in the profit and loss account" has a separate classification in Accounting parlance, and considering the restrictive meaning given in the Act to "Free Reserves", Surplus in the profit and loss account cannot be classified under the head "Free Reserves", although it has the inherent characteristic of being used for distribution as a dividend, being an amorphous mass not identified for application for any specific purpose.
It is therefore clear that the law intends to drive a wedge conceptually between Free Reserves and the surplus in the profit and loss account despite the fact that a common thread runs through them in that both represent undistributed profits, as an amorphous mass.
Table F in Schedule I recognizes the distinction between Free Reserves and Surplus
The above distinction also stands fortified by the provisions contained in Table F of Schedule I of the Act. Table F in the Statute provides the standard Articles which can be applied by a company if it does not wish to draw up its articles on its own. Clause 82 (i) therein provides that the Board, may, before recommending any dividend, set aside out of the profits of the company such sums as it thinks fit as a reserve or reserves which shall, at the discretion of the Board, be applicable for any purpose to which the profits of the company may be properly applied including a provision for meeting contingencies or for equalizing dividends; and pending such application, may, at the like discretion, either be employed in the business of the company or be invested in such investments (other than shares of the company) as the Board may, from time to time, thinks fit.
Clause 82(ii) stipulates that the Board may also carry forward any profits which it may consider necessary not to divide, without setting them aside as a reserve.
Thus Schedule I in the Act itself gives to the Board the flexibility to treat a portion of the undistributed profits as part of "Reserves" or to carry forward the same as a surplus without setting them aside as a reserve.
It is pertinent to note that although Schedule F has no mandatory application for all classes of companies, its relevance cannot be underscored considering that it is part of the Act. Schedules that are appended to an Act form part of the Statute as held in Ujagar Prints v Union of India (AIR 1989 SC 516 at pages 531 and 532) and in many other cases. The division of a statute into Sections and Schedules is a mere matter of convenience and a Schedule therefore may contain substantive enactment which may even go beyond the scope of the Section to which the Schedule may be connected by its heading. It has been held that in case of a conflict between the body of the Act and the Schedule, the Act shall prevail. (Aphali Pharmaceuticals Ltd v State of Maharashtra (AIR 1989 SC2227). It is pertinent to note from the provisions of Section 2(43) that "Free Reserves" are those that stand transferred to "Reserves" not intended for specific purposes. On the other hand, Surplus in Profit &Loss Account has a separate classification under the Accounting convention under the head "Surplus" as specified in Schedule III to the Act as elaborated above. Looking at the contents of Schedule III as also based on the reading of the relevant clauses in Table F in Schedule I as reproduced above, it can be inferred that the intention of the law is to differentiate between surplus and reserves and treat them as separate and distinct species. Profits of earlier years remaining undistributed not transferred to Free Reserves would form a part of "Surplus" and not be a constituent of "Reserves" of the genre contemplated within the meaning of Section 2(43).
Differences between General Reserve and Surplus in Profit and loss Account under the Income Tax Act, 1961
The distinction between "General Reserves" which expression is synonymous with "Free Reserves" and surplus in profit& loss account has also manifested itself in Jurisprudence under the Income Tax Act, 1961. The distinction has been drawn, albeit, for specific purposes under the Income Tax Act. However, such references are also relevant for the purposes of the issues dealt with in this exposition.
It is pertinent to refer to some passages of the decision of the Appellate Tribunal (Bangalore Bench)of the Income Tax Appellate Tribunal in Appeal No.(ITA 861/Bang./2010 ) involving Canfin Homes Ltd v Deputy Commissioner of Income Tax which is of significance to this discussion. In the said case, the Assessee claimed exemption under Section 36(1)(viii) of the Income Tax Act holding out that it should get a deduction on the aggregate of its paid-up share capital, General Reserves, amount standing to the credit of Securities Premium Account and surplus standing to the credit of the profit &loss Account.
It is pertinent to note that the expression"Reserves " has not been defined under the Income Tax Act. It has, therefore, to be understood in the manner in which it is used in commercial parlance.. A reserve by its very nature is a fund that is created and maintained for the purpose of being drawn up in the future. The Assessee had intended to bring share premium and profit and loss account balance into the definition of the reserve.
In its order, the Tribunal observed that:
" A mass of undistributed profits cannot automatically become a reserve and somebody possessing the requisite authority must clearly indicate that a portion thereof has been earmarked or separated from the general mass of profits with a view to constituting it either as a general reserve as a specific reserve. In order to constitute a reserve, however, there must be a conscious act by the company withholding an amount and the word reserve can have no application to profits with respect to the application of which there is as yet, neither a proposal nor a decision. A Reserve may be a general reserve or a specific reserve, but in order to constitute a reserve, there must be a clear indication to show that it was a reserve either of the one or the other kind. A mass of undistributed profit is not a reserve even though it is shown in the balance sheet as a reserve."
While drawing the above distinction the Bench placed reliance on the decisions in CIT v. Gordon Wood Roffee and Co., (Madras) Pvt. Ltd (: 183 ITR 465) and Indian Steel and Wire Products v. CIT (: 33 ITR 579).
The above judgment was delivered by the Bench on 24.1.2012 and reference has been made therein to several precedents on the same issue.
The above arguments conclusively prove that "surplus" in the profit and loss account does not form a part of "free reserves" as contemplated under Section 2(43) of the Act.
Retaining undistributed profits to the credit of Profit and loss Account –a preferred option for distribution of Dividend
Section 123(3) of the Act as stated above facilitates the use of the surplus in profit and loss account for the distribution of interim dividends. On the other hand, where a company proposes to declare a final dividend out of its free reserves, it has to ensure compliance with the requirements of Rule 3 of the Companies(Declaration and Payment of Dividend)Rules, 2014. The plain reading of the above rule makes it clear that the law does not contemplate the distribution of interim dividends out of free reserves.
It is also pertinent to note that as stated in clause (j) under sub-section (3) of Section 134 it is no longer compulsory for a company to transfer out of its profits any amount to any reserves of the company. If any transfer has been made to the Reserves, the fact of such transfer shall be reported by the Board to its members. The use of the expression"if any" in the above clause makes it clear that the company can exercise its option in this regard. The above position is in contrast to the provisions contained in Section 205(2A) of the 1956 Act read with The Companies (Transfer of Profits to Reserves)Rules, 1975 in terms of which it was, inter alia, necessary to transfer a certain percentage of the net profits compulsorily to the Free Reserves for declaring any dividend beyond 10%.
The present Act, therefore, provides the flexibility to the Board to retain the undistributed profits of the company as an amorphous mass in the shape of Surplus in the Profit and loss Statement into which the Board can dip into in future if need be, for declaration of interim dividend. The amount so retained can also be used for the distribution of the final dividend without being constricted by the dictates of Rule 3 supra referred to above.
A surplus in Profit and Loss Statement not being part of "Free Reserves"- Implications thereof
Despite the fact that both Surplus in Profit & Loss Account and Free Reserves have something in common between them, namely that they both represent undistributed profits for past years, they are classified differently under the Act as demonstrated above. The fact that the surplus in the profit and loss statement does not form a part of "free reserves" throws up some consequences which were perhaps not visualized or intended by the Legislature. These need to be elaborated.
Under Section 180(1)(c) of the Act, a public limited company needs the authorization of its shareholders for resorting to borrowings in excess of the aggregate of its paid-up share capital, free reserves, and securities premium. As any surplus in the profit and loss account is not part of free reserves, the same cannot be taken into consideration for the purpose of determining the borrowing limits of companies. Their capacity to borrow will be curtailed due to the non -inclusion of the surplus in the above aggregate.
Similarly, under Section 186, a public limited company needs the authorization of its members by special resolution if it wants to make investments in other bodies corporates or to make loans/provide guarantees, etc. if the aggregate of the same is intended to exceed sixty percent of its paid-up share capital, free reserves and securities premium or one hundred percent of its free reserves and securities premium account whichever is more. For the purpose of computing the above limit also the surplus in the profit &loss statement shall not be taken into account.
The above give rise to an anomalous position in the Statute in that despite the commonality that runs through them, Free Reserves and Surplus in the Profit & loss statement need to be treated differently in the Statute for specific purposes.
A surplus in Profit & Loss Statement forms part of "Net worth" under amended Section 2(57)
The term "net worth" has been defined restrictively by Section 2(57) to refer to the aggregate value of the paid-up share capital and all reserves created out of the profits of the company after deducting the aggregate value of accumulated losses, deferred expenditure, and miscellaneous expenditure not written off, as per the audited balance sheet but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation.
It is pertinent to note that through an amendment made to the definition by the Companies (Amendment)Act, 2017 notified with effect from 9.2.2018, apart from Securities premium account, the debit or credit balance of profit and loss account shall form a part of the "Net worth". Any credit balance in the profit and loss account, shall with effect from the date of the above amendment bolster the quantum of the net worth of the company. Any debit balance in the profit and loss account will have the effect of lowering the quantum of net worth.
Reference to the definition of "net worth" and the amendment thereto is relevant for the purpose of the discussion since it clearly drives home the point that the legislature intends to provide a separate identity to Free Reserves and to the credit or debit balance in the profit and loss account as manifested in the amendment made to the definition under Section 2(57).
Considering the above, it would be appropriate if the borrowing limits and the thresholds for making of loans and investments, respectively under Sections 180(1) (c ) and 186 are determined with reference to the company’s net worth so that the company’s capacity on both accounts is not inhibited unfairly due to the elimination of the surplus in the profit and loss statement from the ambit of "free reserves". A review of the law would appear to be appropriate, given that both represent amounts that have not been earmarked for specific purposes and hence are "free" for utilization for such purposes as deemed appropriate.
Conclusion
In the above discussion, the nuances of the law have been articulated to bring out the fine and blurred line which demarcates a "free reserve " from a "surplus". Given the commonality that runs through the two conceptually a distinction may appear unnecessary. The way forward appears to be to remove the anomalies in the law on the subject as demonstrated above. Until that happens, we have to live with the Statute as it stands since one does not have the liberty to tweak the law to one’s own advantage.
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