Appropriation to General Reserves - A Superstition

As most of us are aware, the requirement of mandatory appropriation of certain amount of profit to reserves (popularly known as General Reserves) before declaring/paying dividend has been done away with after sec. 123 of the Companies Act, 2013 (Act) came into effect. However, we find that most companies still appropriate a certain portion of profits to General Reserves.

This article analyses the impact of such appropriation and the industry practice.

Impact of appropriation to General Reserves

After appropriating the amount to statutory and other specific reserves, under the Companies Act, 2013, as a company is not mandated to transfer any portion of profits to General Reserves, it has two options before declaring a dividend i.e. either to appropriate to General Reserves or not to appropriate an amount to General Reserves. In the later case, any credit balance of Profit & Loss Account which is not appropriated shall remain as Surplus and shall be shown separately under head Reserves & Surplus. (Refer Schedule III of the Act). Therefore, any company before declaring the dividend should analyse the impact of going ahead with either option.

Before proceeding with the impact, it is pertinent to refer to relevant extracts sec. 123 of the Act, which is reproduced below: 

“(1) No dividend shall be declared or paid by a company for any financial year except—

(a) out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2), or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with the provisions of that sub-section and remaining undistributed, or out of both; or

                                 …….

Provided that…..

Provided further that where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividend out of the accumulated profits earned by it in previous years and transferred by the company to the reserves, such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf:

                …….

(3) The Board of Directors of a company may declare interim dividend during any financial year out of the surplus in the profit and loss account and out of profits of the financial year in which such interim dividend is sought to be declared:”

It is aptly clear that accumulated profits earned in the previous years arrived after providing for depreciation is nothing but Surplus of Profit & Loss Account, whereas accumulated profits earned in the previous years and transferred to the reserves, include General Reserves.

Based on the above, an evaluation of impact of both the options under various circumstances has been presented in the following table: 

Table: Evaluation of impact of both the options

Events	Option – Retain as Surplus and not appropriate to General Reserves	Option – Appropriate a part of the profits to General Reserves
Declaration of Final Dividend	Surplus is available for declaration of dividend as per sec. 123 (1) (a) of the Act.	Dividend can be declared out of General Reserves subject to certain restriction, as per proviso 2 to sec. 123 of the Act read with Companies (Declaration and Payment of Dividend) Rules, 2014.
Declaration of Interim Dividend	Surplus is available for declaration of Interim Dividend	General Reserves is not available for declaration of Interim Dividend

Considering, that the impact is only with respect to declaration of dividend, it is prudent that the Board keeps the option open for the shareholders and does not propose appropriation of part of profits to General Reserves.

Industry Practice

Interestingly, an analysis of companies considered in the NIFTY 50 Index shows following results:

·        In FY 2014-15, about 19 companies (38%) decided not to appropriate any amount to General Reserve.

·        The scenario has slightly changed in FY 2015-16 with about 26 companies (52%) deciding not to appropriate any amount to General Reserves.

It is pertinent to note that out of the two companies (ie. Hindustan Unilever Limited and Tech Mahindra Limited) which have not appropriated any amount to General Reserves, have in fact, transferred/proposed to transfer the balance lying in General Reserves to Surplus of Profit & Loss Account.

Conclusion

It can be concluded that retaining the profits in Surplus makes sense and the same could be used for dividend, without any restriction which would otherwise be applicable for declaring dividend out of General Reserves. Further, based on the limited study it appears that the Management of many companies have continued the age old practice of appropriating certain percentage of profits as per the provisions of the Companies Act, 1956 and have not applied efforts to identifying the benefits of the alternate option of retaining the amount as Surplus of Profit & Loss Account. Therefore, I believe that the appropriation to General Reserves is a Superstition practiced by the Management of many companies.