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MASTER OF COMMERCE
in
ACCOUNTING
in the
at the
SUPERMOR: D. N. STEGMANN
MOVE IV ER 1996
Hierdie verhandeling is opgedra aan my man Re. Re, ek sou nie
en liefde nie.
Glory to the Holy Trinity. I have been privileged to receive talents in abundance from God.
My husband and best friend, thankyou for believing in my. Re, you have been true to your
nature in your patience, understanding and enthusiasm for this thesis. I love you, always.
My thanks to my father, Gilliam and my mother, Lallie Lotter for all the sacrifices that they
have made in order to give me so many opportunities in life. I hope to have them with me
in good health in this life for a long time. A special thankyou to my father. You taught me
that I should always give my best in life. You taught me about tenacity. A special thankyou
to my mother. Your never failing faith has always been an example to all of us.
,My thanks to the rest of my family for their continued support. My father-in-law, Andre and
mother-in-law, Joey Voogt. My brother, Michiel and sister-in-law, Ansie Lotter. My sister-
in-law, Hanlie Voogt.
In completing this thesis, I have learnt a great deal about dividends and accounting
principles. Without the regular, positive feedback and continued encouragement from
Dr. Nerine Stegmann, it would not have been possible.
Lastly, I had a patient, ever-present companion during the long days spent working on this
thesis. Thankyou to Jack, the best Jack Russell a woman could have.
Foreword
S MEVATTING
Individue en institusionele beleggers wat in die aandele van maatskappye bele, dra 'n
bepaalde risiko om 'n opbrengs in twee vorms te verdien. In die eerste plek wil beleggers
'n kapitaalgroei realiseer by die verkoop van die aandele en in die tweede plek hoop
beleggers om dividendinkomste te verdien totdat die aandele verkoop word.
Dividende het 'n hoe inligtingsinhoud. Beleggers en potensiele beleggers gebruik dividende
en dividende per aandeel dikwels as 'n maatstaf van die sukses van 'n maatskappy.
Die doelwit van hierdie verhandeling, is die studie van 'n wye reeks van reels en
aangeleenthede wat oorweeg moet word by die berekening, verklaring en betaling van
dividende in die huidige Suid-Afrikaanse milieu.
Die kwessie van dividende bring etlike vraagstukke na yore wat in hierdie studie.ondersoek
word. Hierdie kwessies sluit 'n ondersoek in om 'n eenvormige definisie vir dividende te
bepaal asook 'n gedetailleerde, kritiese analise van die gemeenregtelike dividendreels wat
gebruik word in die berekening van die maksimum bedrag wat regtens beskikbaar is vir
verklaring as dividende. Die berekening van wins wat regtens bekikbaar is vir verklaring as
dividende, word gebaseer op die finansiele state van 'n maatskappy. Hierdie finansiele state
bevat nie perfekte inligting nie en die inligting in finansiele state kan gemanipuleer word ten
einde rekeningkundige wins te verhoog vir doeleindes van die berekening van dividende.
Nadat die problematiek rondom finansiele state ondersoek is, fokus hierdie studie verder
op die keuses wat deur direkteure uitgeoefen kan word by die bepaling van 'n spesifieke
dividendbeleid wat geImplementeer moet word en die voordele en nadele van verskillende
dividendbeleide. Nadat die direkteure van 'n maatskappy 'n spesifieke dividendbeleid vir
implementering gekies het, gaan die studie voort om 'n aantal reels en wetsbepalings te
ondersoek wat in ag geneem moet word by die betaling van dividende, voordat die
direkteure die vorm waardeur dividende betaal kan word sal kies.
Dividende kan in 'n wye verskeidenheid van vorms betaal word. Twee van die algemeenste
vorms van dividende tans in Suid -Afrika, is die betaling van kapitalisasie aandele en
skripdividende. Beide hierdie vorms van dividende het algemene gebruik geword met die
Foreword
bestudeer 'n wye reeks van aspekte rondom kapitalisasie aandele en skripdividend in detail.
Die fokus van hierdie verhandeling is om lig te werp op dividende uit die oogpunt van klein
individuele beleggers en meer spesifiek, swart individuele beleggers. Een van die doelwitte
van die . Johannesburgse Effektebeurs is om die koopkrag van hierdie beleggers so you
moontlik na die Beurs toe te kanaliseer. Aangesien hierdie beleggers gewoonlik nie
van die kant van die Beurs en van die kant van individuele maatskappye af. Hierdie groepe
bie betaling van dividende raak egter nie net individuele maatskappye en hul beleggers nie.
Die kollektiewe dividendbesluite van maatskappye in die Suid-Afrikaanse ekonomie het 'n
impak op die sukses van die Heropbou-en-ontwikkelingsprogram. 'n Aantal faktore wat in
hierdie verband oorweeg moet word ten opsigte van dividende, is ook in hierdie studie
gedokuMenteer.
Index iii
CHAPTER 1 - INTRODUCTION 1
2.1. Introduction 9
2.2. Definitions for dividends 9
2.2.1. Introduction 9
2.2.2 Linguistic and legal definitions 10
2.2.3. Accounting definitions 10
2.2.4. Definitions of the Courts and the Companies Act 11
2.2.5. The Income Tax Act definition 12
2.2.6. Conclusion 21
2.3. A payment, allocation or division of some form 21
2.4. Sourced from profit, income or a fund 23
2.4.1. Introduction 23
Index iv
2.4.3.4. Conclusion 28
2.4.4. Legally divisible profit 28
2.4.5. Conclusion 30
2.6.9. Conclusion 43
2.7. Summary 44
Bibliography 45
3.1. Introduction 48
3.5.1. Introduction 53
account
3.9. Rule 5 - Realised profits on the sale of fixed assets may be distributed 74
3.10. Rule 6 - Unrealised profits on the revaluation of circulating or working 75
capital may be distributed
3.11. Rule 7 - Unrealised profits on the revaluation of fixed assets may be 77
distributed
3.11.1. Introduction 77
3.11.2. Case law and other views against the distribution of 78
unrealised profit on the revaluation of fixed assets
Index vi
4.1. Introduction 98
4.2. Accounts, balances or values referred to by the common law dividend 98
rules
4.3. Constraints on financial statements 99
4.3.1. Introduction 99
4.3.2. Timeliness 100
4.3.3. Balance between benefit and cost 100
4.3.4. Balance between qualitative characteristics 101
- 4.3.4.1. Understandability 101
4.3.4.2. Relevance 102
4.3.4.3. Reliability 102
Index vii
CHAPTER 6 -RULES FOR THE PAYMENT OF, AND DIFFERENT FORMS OF 135
DIVIDENDS
dividends
8.8.4. Accounting entries at the finalization of the DRP 203
8.8.4.1. The bonus share approach 204
Bibliography 213
THERETO
or a fund
9.2.1. Introduction 216
9.2.2. Defining problem number 1 217
•
Index xii
CHAPTER 1 - INTRODUCTOOM
"Neither man nor nation can exist without a sublime idea." - Feodor Dostoevski
(Peter, 1977:258).
One of the main features of a market economy, is the ability of individuals to create
wealth. Through these individuals, institutions such as companies and banks should also
accumulate wealth (Puxty & Dodds, 1988:3). The wealth created in a market economy
should either be consumed or reinvested.
The consumption of wealth satisfies some of the needs of individuals. One of the theories
that has been documented on the needs of individuals, is the motivation theory developed
by Maslow. Maslow proposed that the needs of all individuals can be arranged in a
hierarchy of relative pre-potency. Each level of need remains dominant until that need is
satisfied. Only then would a new level of need become the prime motivating factor for an
individual's behaviour. The Maslow hierarchy of needs is shown in Table 1.1. (ACCA,
1994:108). The first need that individuals strive to meet is the primary physiological need.
TABLE 1.1.
MASLOW'S HIERARCHY OF NEEDS
others
threat
The reinvestment of wealth will generally be channelled into various institutions where the
funds owned by individuals and corporate investors may create real wealth in the form of
assets (Puxty & Dodds, 1988:27).
The wealth that may be created through investment on the stock market is two-fold in
nature. Firstly an investors could earn capital growth. The capital growth will be equal to
the difference between the initial purchase price and the eventual selling price of the shares
in which an investor has invested.
Secondly, an investor may earn dividend income on the shares that he has invested in. This
dividend income will increase the wealth of the investor as it may be used to better the
situation of the investor. The dividend income may be utilised to purchase goods and
services to fulfil personal potential or may be reinvested to create even more wealth though
additional investments in shares.
The value of the dividends that investors receive, play an important role in investment
decisions. The South African Institute of Chartered Accountants (hereafter referred to as
Dividends and dividends per share have information content. Dividend announcement are
Chapter 1 - Introduction 3
often associated with movements in share prices beyond a specific expectation (Puxty &
Dodds, 1988:209). The impact of dividends and dividends per share on a company and the
shareholders of a company can be significant. Individual investors, in particular, place great
importance on the value of dividends they receive on their investment in shares. Dividend
information signal the potential earnings power of a company (Peterson, Millar & Rimbey,
1996:249). Any decision that affects dividends and any decision on dividends, therefore,
need careful consideration by those who take the responsibility in this regard.
The purpose of this thesis is to study the calculation, declaration and payment of
dividends. This study of dividends will be undertaken from an accounting point of view
with specific reference to requirements in the Companies Act (hereafter referred to as the
Act) and principles established in 'common law.
The thesis will initially investigate the definitions attributed to dividends and the calculation
of the maximum amount that may be legally declared as dividends. This calculation will,
generally, be based on the financial statements of a company. The dividend decision will
have to take into account that financial statements may not include perfect information.
The maximum'amount legally available for distribution as dividends do not necessarily have
to be declared as dividends. The amount declared as dividends may be reliant on the
dividend policy adopted by a company and the form that the company selects for the
payment of dividends.
This thesis will focus, in particular, on the dividend decisions of South African companies.
The study will, however, not be limited to the effect of dividends on investors in the shares
of companies. The dividend needs of a host of stakeholders will be addressed as well as
a number of issues that need to be addressed in relation to the South African government's
Reconstruction and Development Program.
The motivation and purpose of this study which was documented above, can not be
Chapter 1 - Introduction 4
The rules applied in the calculation of profit legally available for distribution as
dividends will be studied in detail from a modern conceptual accounting point of
view. The effect of the application of some of the more controversial dividend rules .
will be studied in order to show the impact of the application of these rules on the
financial statements of a company.
The application of the common law rules in South Africa will also be compared to
the position in European countries where common law principles have been
explained or outlawed explicitly through legislation.
After the maximum amount available for distribution as dividends has been
calculated based largely on financial statements, the directors of a company need
to decide whether the entire amount will be declared as dividends. This decision will
be reliant on the dividend policy that the company has adopted. Chapter 5 studies
a number of dividend policies and the effect of each of the policies on the income
statement of a company.
The dividend policies adopted collectively by all companies in South Africa, affects
not only these companies, but also the population at large in its effort to succeed
in attaining the goals set by the Reconstruction and Development Program.
1.3.5. Ch pter 6 uses for the payment of, and different forms
of dividends
The diVidend decision does not end at the determination of the final amount of
dividend that should be declared. A number of rules need to be considered before
the announcement of a dividend declaration can be made as these rules may place
Chapter 1 - Introduction 6
The directors of a company are further not limited to the payment of dividends in
the form of cash. There are a number of other forms that be used in order to pay
dividends. Two dividend forms that have become prevalent in South Africa, have
been the issue of capitalization awards and the payment of scrip dividends. Both
these dividend payments will be studied in detail.
Apart from the definitions for and taxation considerations, a number of reasons for
the issuance will be studied. The accounting implication for the issuance will also
be studied and documented.
Chapter 8 will investigate reasons for the payment of scrip dividends, requirements
that need to be met in this regard and the accounting entries that should be passed
in order to account or the payment and receipt of scrip dividends.
This study of dividends will undoubtedly identify a range of problems that should
be addressed in a number of ways. Chapter 9 will propose a number of
recommendations that may be implemented in order to overcome problems so
identified.
The purpose of this, the last chapter of this thesis, will be to summarize the findings
of the study. A number of specific fields that may be addressed in new studies on
dividends will also be documented.
Chapter 1 - Introduction 8
13DBLOOGR plily
ACCA 1994: ACCA Study Text Foundation Paper 4 The Organisational Framework.
London: BPP Publishing Limited.
DIVARIS, C 1975: Scrip Dividend: A Blunder. Businessman's law, June 15 1975: 181-
182.
PETER, L 1977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
PUXTY, AG & DODDS, JC 1988: Financial management method and meaning. London:
Nostrand Reinhold (International) Co. Ltd.
SOUTH AFRICA (Republic). Acts, statutes etc.: Income Tax Act (Act 58 of 1962 as
amended). Pretoria: Government Printer.
"If a rich man is proud of his wealth, he should not be praised until it is known how
he employs it." - Socrates (Peter, 1977:492).
2.1. kytvoduction
Ask any person (whether he owns shares or not) what dividends are, and he would tell you
that it is money, profit or income received from a company in which you made an
investment. Dividends are regarded as just reward for taking some measure of risk.
Regardless of his explanation of dividends, this person would be able to tell you that it is
an important ratio, amount or statistic.
Dividend payments, or the lack thereof, hit the news headlines frequently. Particularly with
regard to gold mining groups, it is perceived as a measure of the worth and future of that
industry (Valentine, 1 995:S9).
The perception that dividends are important, creates many questions. For example, how
much should this dividend be, is it only paid in cash, is it only paid out of profit, should one
receive dividends every year, can shareholders decide when dividends are to be paid and
very importantly, do dividends really matter. Bold statements such as those of G. Bennet
Stewart, Ill (1991:43), even go as far as disputing that there is merit in the payment of
dividends (Stewart's theory is discussed in paragraph 5.8.2.). Many of the questions
raised, relate to the different meanings or definitions attributed to the term "dividends".
2.2.1. Ontroduction
The introduction to AC 104 Earnings and dividends per share (SAICA, 1 992:par.01)
proclaims that dividends per share assists the users of financial statements in
evaluating a company's current performance and comparing this performance to
The Oxford Dictionary defines "dividends" as a sum that is payable as profit out of
joint-stock companies, where joint-stock refers to capital held jointly in a common
fund (The Concise Oxford Dictionary, 1982:281,541).The "HAT" defines dividends
as a share of profit that is paid to shareholders (Verklarende Handwoordeboek van
die Afrikaanse Taal, 1988:160).
The term "dividends" is frequently not defined on its own in accounting literature.
Dividends usually only appear as part of concepts such as "dividends per share",
"dividend yields" etc. that are defined as a whole. This is a peculiar situation, as
apart from the restrictions imposed by the articles of association of a company,
governmental regulations, the profitability of a company, taxation considerations
and the status of a company on capital markets, the payment of dividends is also
governed by restrictive common law rules. The lack of accounting definitions for
Chapter 2 - A definition for dividends 11
Accounting literature that has ventured into defining dividends has classified it,
among others, as being a payment designated by a company's board of directors
to be distributed among shareholders or stockholders (Johnson, 1 983:453). Shares
and stocks are generally regarded as synonyms. The term "stocks" is used more
frequently in the United States of America. If a distinction is made between the two
concepts it will relate to a shareholder only owning shares and a stockholder
owning shares but also unit trusts, securities etc. Stocks may also be defined as a
consolidated block of shares as defined by Naish LC in the case of Dillon v Arkins
(1885) 17 LR Ir 636 at 637-8 (Van Dorsten, 1993:20).
The Courts have also had an opportunity to define the term "dividends" (Van
Dorsten, 1993:25,26). Lord Cranworth LC said in Henry v Great Northern Railway
Co (1857) 27 LJ Ch 1 (CA) at 15, that if one looks at the derivation of the word
"dividend" it means a fund to be divided, not the share of any particular partner or
person in that fund. In Staples v Eastman Photographic Materials Co [1896] 2 Ch
303 (CA) at 307-8, Kay LJ suggested that the word dividend was taken from the
word dividendum, the thing to be divided, to which each person is entitled. In Re
Crichton's Oil Company [1902] 2 Ch 86 (CA) at 95, Stirling LJ said that a dividend
is a prima facie payment made to a shareholder while the company is a going
concern.
One would have expected that the Act would provide us with a definition for this
important concept in the light of the perception that the Act should provide some
degree of investor protection. This is, however, not so. The only related definitions
provided in the Act, is that for a "company" and a "share" (South Africa, 1 973).
Section 1 defines a "company" as one registered in terms of Chapter Four of the
Act. Chapter Four of the Act deals with section 32 to 73 regarding the formation,
Chapter 2 - A definition for dividends 12
Schedule 1 of the Act provides a number of rules that may be applied in the
calculation and declaration of dividends, including the fact that it is the
responsibility of the directors of a company to calculate such an amount (South
Africa, 1 973). The Companies Act requirements for the payment of dividends are
discussed in paragraph 6.2.2.
The Income Tax Act (South Africa, 1 962) provides us with an extensive definition
of dividends in section 1. Because reference will be made to this definition in other
chapters, it will be provided here in full. This definition (with the most important
issues, for the purposes of this thesis, underlined) reads as follows:
"'dividend' means any amount distributed by a company (not being a mutual
building society or an association or institution to which section 10 (1) (d)
applies) to its shareholders or any amount distributed out of the assets
pertaining to any unit portfolio referred to in paragraph (e) of the definition
of "company" in this section to shareholders in relation to such unit portfolio
(including, in the case of any co-operative society or company referred to in
section 27, any amount distributed on or after 1 April 1977 to its members,
whether divided among the members in accordance with their rights as
shareholders or according to the value of business transactions between
individual members and such society or company or on some other basis),
and in this definition the expression 'amount distributed' includes-
(a) in relation to a company that is being wound up or liquidated, any
profits distributed, whether in cash or otherwise, other than those of
a capital nature, earned before or during the winding-up or liquidation
(any such profits distributed by the liquidator of the company being
deemed for the purposes of this definition to have been distributed
by the company);
Chapter 2 - A definition for dividends 13
is reduced; and
in the event of the reconstruction of a company so much of the sum
of any cash and the value of any assets given to a shareholder as
exceeds the nominal value of the shares held by him before the
reconstruction,
but does not include -
Provided that the provision of paragraph (g) and (h) shall not apply in respect
of the nominal value (or any portion thereof) of any capitalization shares
awarded before 1 January 1974 by any company which is recognized as a
private company in terms of section 38:
Provided further that, for the purposes of this definition -
(i) where a company has on or after 1 January 1974 transferred
any amount from reserves (excluding any share premium
account) or undistributed profits to the share capital or the
share premium account of the company without applying the
amount in paying up capitalization shares or has applied the
amount in paying up capitalization shares the nominal value
of which did not in whole or in part constitute an amount
distributed as contemplated in the foregoing provisions of this
definition, the amount so transferred (reduced by so much
thereof as constitutes such an amount distributed) shall be
deemed -
(aa) to the extent that such amount (as so reduced) is
shown to consist of profits of a capital nature
available for distribution by the company to
shareholders who, in the event of a distribution by the
company at any time (whether before or during the
winding-up or liquidation of the company) of profits of
a capital nature would be entitled to participate in such
a distribution; and
shareholders;
(iii) if, in the event of the subsequent partial reduction or
redemption of the share capital (including any share premium)
of the company or the reconstruction of the company, any
cash or any asset is given to shareholders and such cash or
asset (or a portion thereof) represents a return of share capital
or share premium, the amount of share capital or share
premium so returned -
shareholders -
and
(B) any such profits which are not of a
capital nature and relate to shareholders
entitled to participate in profits which
are not of a capital nature, are reduced
by so much of the loss of the said share
capital as is attributable to losses which
are not of a capital nature; and
(bb) the aggregate of any cash and the value of any
assets given to shareholders entitled to
participate in profits not of a capital nature
shall, to the extent that such aggregate
exceeds so much of the sum of the share
capital and any share premium contributed by
such shareholders (less so much of such share
capital and share premium as has been lost) as
remains after deducting therefrom an amount
equal to so much of any profits, not of a capital
nature, which are deemed by this proviso (after
applying subparagraph (aa) of this paragraph)
to be available for distribution to such
shareholders at the commencement of the
winding-up or liquidation, as relates to the said
share capital, be deemed to be a profit, not of
a capital nature, distributed to such
shareholders, but the amount of that profit
shall not be determined at an amount which
exceeds the aforesaid amount;
Provided further that for the purpose of this definition an asset shall be
deemed to have been given to a shareholder of a company if any asset or
any interest, benefit or advantage measurable in terms of money is given or
transferred to such shareholder or if the shareholder is relieved of any
obligation measurable in terms of money;
Provided further that a reserve of any company which consists of or includes
Chapter 2 - A definition for dividends 21
any amount transferred from the share premium account of the company
shall, except to the extent to which such reserve consists of any other
amount, be deemed for the purposes of this definition to be a share premium
account of, or share premium received by, such company."
2.2.6. Conclluson
The various forms of literature that have provided us with a number of ways of
defining dividends, have shown the different emphases that may be placed on the
term.
The following similarities can be extracted from the definitions discussed above:
it is a payment, or allocation, or division of some form (discussed in
paragraph 2.3.);
sourced from profit, or income, or a fund (discussed in paragraph 2.4.);
made to shareholders (discussed in paragraph 2.5.) and
authorised by the board of directors of a company (discussed in paragraph
2.6).
The first attribute of the definition that will be discussed is the fact that dividends
are payments, allocations or divisions of some form.
The share capital of a company may be divided into share capital having a par value or
share capital having no par value as stipulated by section 74 of the Act (South Africa,
1 973). Companies have a number of options available when issuing shares to investors
Chapter 2 - A definition for dividends 22
from either of the two categories of share capital. They may choose (but are not limited
to) any of the following options:
ordinary shares;
preference shares or
deferred shares.
The presumption of equality does not apply when determining the terms of an issue of
shares in relation to other categories already in issue. Shares will fall into different
categories with distinct rights attaching to them that may be different to other share
categories in issue. Shares may have different rights in different classes and different rights
to participate in the assets of a company on liquidation and in the dividend distributions
made to shareholders (Van Dorsten, 1993:16). The rights of each particular class of shares
are open to scrutiny as it is disclosed in the financial statements (Usko Limited, 1993:16),
memorandum of association (section 52 (2)) and articles of association (line 3 of Table A
or line 4 of Table B of Schedule 1) of a company (South Africa, 1 973).
The future needs of the company will determine which form of dividend payment will be
made to shareholders. The decision on the form of dividend payment that is to be made,•
has to be influenced by whether there is profit, income or a fund available for that purpose.
Chapter 2 - A definition for dividends 23
2.4.1. Introduction
The profit, income or fund from which dividends could be sourced, has a number
Of meanings, depending on the context and time frame in which it is used. The
following terms that were frequently used interchangeably, are not necessarily
synonyms:
distributable profits;
net profits;
divisible profits;
distributable income;
net income;
divisible income and
shareholders funds.
The accounting definitions for the terms "profit", "income" or "a fund available for
distribution" needs further attention.
The elements of financial statements can be divided into five categories. The
elements that are directly related to the measurement of the financial position of a
company in its balance sheet, are assets, liabilities and equity. The elements that
are directly related to the measurement of performance in the income statement of
a company are income and expenses (SAICA, 1 990:par.47).
Income and expenses are defined in AC 000 Framework for the preparation and
presentation of financial statements. Income is the increases in economic benefits
during the accounting period of a company, in the form of inflows or enhancements
Chapter 2 - A definition for dividends 24
Paragraph .06 of AC 103 Net profit or loss for the period, fundamental errors and
changes in accounting policies is emphatic that all items of income and expenses
recognised in a period, should be included in the determination of net profit or loss
for the period (SAICA, 1995).
Another related definition is that for revenue. AC 111 Revenue defines "revenue"
From the above explanation, it is clear that the definitions for income and revenue
are very similar. Income, however, includes all inflows for a period, whilst revenue
relates to inflows in the ordinary course of the activities of an organisation.
Profit will be less than both income and revenue as it is calculated after deducting
expenses from revenue and/or income. Profit is dependent upon the recognition and
measurement of income and expenses which in turn depends on the concepts of
capital and capital maintenance (Everingham & Hopkins, 1995:6-11).
Chapter 2 - A definition for dividends 26
Hendriksen and Van Breda holds the view that income may be approached in three
different ways, being:
syntactically, that is, through the rules that define it;
semantically, that is, through its relationship to underlying economic realities
and
pragmatically, that is, through its use by investors regardless of how it is
measured or what it means (1992:308-341).
a company.
2.4.3.4. Conclusion
Prior to the introduction of AC 103 Net profit or loss for the period, fundamental
errors and changes in accounting policies in March 1995, South African companies
referred to profit in a number of ways as reflected in Table 2.1.
companies in reporting results in the their, income statements. After dividends have
Chapter 2 - A definition for dividends 29
been deducted from profit for the year, the net result is then referred to as earnings
attributable to ordinary shareholders as is the case in the 1996 financial statements
of The" South Africa Breweries (The South African Breweries Limited, 1996:51).
It appears as if the Courts have been somewhat more consistent in calling profit,
"profit" in the context of dividend law.
TABLE 2.1.
PROFIT IN THE INCOME STATEMENTS OF COMPANIES
1995:24)
1995:30)
The Courts have, over time, developed the term "profit available for dividends" as
The profit line in the income statement and balance sheet of a company is not
necessarily equal to the profit that is legally available for the declaration of
dividends. Distributable profit has to be adjusted for the implications of the common
law rules set by the Courts. The profit declared in the income statement of a
company may, for example, be adjusted by the depreciation charge on fixed assets
that may be ignored in the calculation of profit available for dividends. The common
Chapter 2 - A definition for dividends 30
law dividend rules have set the parameters within which a company should remain
when calculating or determining its distributable profit available for the payment of
dividends.
2.4.5. Conckaion
Based on the conceptual definitions for profit, income or a fund, dividends should
be paid from profit of some kind.
When it comes to the determination of the amount that a company has available for
the payment of dividends, accountants and the Courts differ. Different rules apply
in determining accounting profit and profit legally available for the payment of
dividends.
Apart from the complicated accounting theory and definitions that has to be applied
in determining accounting profit, accountants may adjust profit further, based on
common law dividend rules that the profession had no control over in calculating
the amount of dividends that may be declared to shareholders. Accounting profit
is merely the starting point for the calculation of profit legally available for the
payment of dividends. Accounting profit is then adjusted for the implications of a
number of common law rules and principles. The common law, legal profit available
for the payment of dividends to shareholders is discussed in detail in chapter 3 of
this thesis.
The third leg of the definition of dividends is that dividends is a payment made to
shareholders.
One of the purposes for investing in the share capital of a company is to earn a return on
that investment.-The return earned by an investor, is normally paid to him in the form of
dividends until the shares are sold and a capital gain or loss realised.
Chapter 2 - A definition for dividends 31
Schedule 2, paragraph (s) of the Act (South Africa, 1 973) states that one of the common
powers of a company is to allow it to distribute in specie or in kind any of its assets among
it members thus allowing dividend payments. Section 103 of the Act (South Africa, 1973)
states that a person is a member of a company once he agrees to become a member and
when his name is entered in the register of members. Many of the rights of shareholders
in respect of dividends are fixed at subscription in the memorandum and articles of
association of a company. Potential •investors should examine the memorandum and
articles of association of a company or a prospectus in the case of new share issues to the
public, so that they are aware of their dividend rights before making an investment.
The board of directors of a company generally has the responsibility for calculating
and authorising the payment of dividends to shareholders, unless it is expressly
under the domain of the shareholders in terms of the articles of association of that
company. This right forms part of the common powers of a company in terms of
Schedule 2, paragraph (s) of the Act (South Africa, 1973) as discussed in paragraph
2.5. This common power allows the company to distribute in specie or in kind any
of its assets among its members. Furthermore if any company has, in its articles of
association, adopted line 84 to 90 of Table A, or line 83 to 89 of Table B of
Schedule 1 of the Act (or indeed have adopted similar stipulations) it has, among
others, the following implications:
the company may declare dividends at the occasion of an annual general
meeting of the company;
such dividends declared may not exceed the amount recommended to the
members by the directors;
the directors may, from time to time, pay an interim dividend to the
members of the company;
no dividends shall be paid otherwise than out of profits, or bear interest
against the company (profits, however, are not defined by the Act);
the directors may set aside any sum out of profits as they think fit as a
. Chapter 2 - A definition for dividends 32
the directors may without placing, carry forward any profits that they may
Although shareholders of such companies might feel as if they have the final say
on the payment of dividends, directors have an effective right in this regard. The
directors have the right to calculate such an amount and it may not be exceeded
by the shareholders of the company. The shareholders have nothing more than a
yea or nay to the proposal of the directors, even if it is not to pay any dividends.
The wording of the articles of association of each company will, however, have to
The rules pertaining to the calculation and authorization of dividends show a clear
the directors who effectively govern the company in materially all respects including
far as the separation of the ownership of a company from the control of the
1993:291).
The men and women who have been appointed to the board of directors' of
headings being:
a duty of loyalty;
The first duty of loyalty places the obligation on directors that they should
To comply with this duty of loyalty the directors should ensure that their is
no conflict of interest between their personal position and their duty towards
In this regard the directors of a company should not use any information that
they have received in their capacity as directors for personal gain. In terms
of sections 234 to 241 of the Act a director may enter into a contract with
the company or on behalf of the company who has employed him as long
as he declares his interest in all material contracts in terms of the Act (South
Africa, 1 973). If these stipulations are not complied with the company then
generally has the option to void the contract at their choice if it appears that
the directors have not complied with their duties of loyalty (Cilliers et al.,
1992:138).
The directors of a company should secondly use their powers solely for the
purpose for which it was given to them. The directors should use their
objectives, a director should ensure that all the benefits derived from the
opportunity go to the company. The personal gain or profit that the directors
may realise should not drive business decisions (Deloitte & Touche,
1995:13).
The third aspect in relation to the loyalty duty of a director is the duty to
440 F of the Act which is a prohibition against insider trading (South Africa,
1973).
A director should ensure that he uses all his powers in good faith for the
benefit of the company.
association of a company.
Except for specific duties that directors have to perform as set out in the Act (South
Africa, 1 973) and articles of association of a company, the articles generally include
a management clause describing the powers and duties of directors. This
Management clause will read as follows for companies that have accepted line 59
of Table A, or line 60 of Table B of Schedule 1 of the Act:
"The business of the company shall be managed by the directors who may
pay all expenses incurred in promoting and incorporating the company, and
Chapter 2 - A definition for dividends 35
may exercise all such powers of the company as are not by the Act, or by
regulations, not inconsistent with the aforesaid articles or provisions, -as may
prescribed by the company in general meeting shall invalidate any prior act
of the directors which would have been valid if such regulation had not been
company dictates that the entire business is under the control of the directors.
Dividend payments would also fall under this ambit as part of the financial and
Financial and treasury management can be defined as the provision and use of
financial resources. The decisions taken in this regard should satisfy the financial
goals of the organisation. The dividend policy that the directors of a company
adopts, also represents a financing decision, since the payout of a cash dividend
issues, would preserve cash in the organisation that would become available for
organisation's share price (Collier, Cooke & Glynn, 1988:3). As dividend policy and
weight.
A company's dividend policy is a key area that is analysed when reviewing the
shareholder will be able to use a company's dividend policy as one of the key
Chapter 2 - A definition for dividends 36
drivers in determining whether the company is bullish or bearish (Ellis & Williams,
would be determined by the way in which the directors fulfil their fiduciary duties.
TABLE 2.2.
DIVIDENDS AS A KEY DRIVER IN ANALYSING A COMPANY
The directors of a company have common law fiduciary duties requiring them to
exercise their powers bona fide and for the benefit of the company. They further
have a responsibility to display reasonable care and skill in carrying out these duties
(Cilliers, Benade, Henning, Du Plessis, Delport, Fourie & De Koker, 1993:132). The
fiduciary duties of directors encompass the stewardship duties of directors.
The existence of these duties is one of the best measures of protection for a
company and its shareholders against directors exploiting their office. A director
acting in good faith for the benefit of the company will, by implication, serve the
shareholders of that company.
The fiduciary relationship and duties exist between a director and the shareholders
as a group. The interests of the shareholders as a whole should be served and not
that of the individual (Cilliers, Benade, Henning, Du Plessis, Delport, Fourie & De
Koker, 1993:138). The case of a major shareholder who is in a financial pickle and
Chapter 2 - A definition for dividends 37
desperately needs dividend income to rectify his situation, may only be acted upon
if such a payment is in the interest of all shareholders and would have been made
in any event. Senior management and the directors' most important goal is, after
greater value and rewards for the shareholders. The creation of such value will
benefit society at large as well (Stewart, 1 991 :1) in fulfilling a company's obligation
as follows:
directors should ensure that they have the time to devote to carry out
directors should be informed about the financial, social and political milieu
decisions;
directors must never permit conflict of duties and interest;
opportunity;
directors must act independently of any outside fetter or instruction;
shareholders' value while having regard for the interest of all stakeholders;
directors must ensure that all interested parties are fully informed of any
material matter affecting the company's business with openness and
directors must exercise the care and skill which can reasonably be expected
of a person of their expertise;
directors must always act in the best interest of the company and never for
any sectoral interest;
directors must ensure that the company's strategy and structure has been
directors must insist that board papers and information are given to them
timeously so that they have time to study them and make properly informed
decisions;
should be treated as such and not divulged to anyone without the authority
of the company;
if a director is in doubt about any aspect of their duties they should obtain
professional advice;
directors must ensure that the company prepares annual budgets against
directors must ensure that procedures and systems are in place to act as
directors must ensure that the board monitors the performance of executive
performance, etc.;
directors must ensure that the company has an affirmative action plan in
the company as in most cases it will be necessary for the long term survival
The King Report of Corporate Governance places emphasis on the role of directors
in the governance of a company. The classical corporate governance model is based
that the company is a legal entity that is separate from the owners;
the company exists in perpetuity since the shares of the company may be
transferred;
Chapter 2 - A definition for dividends 39
the board of directors oversees the running of the company and reports
financial statement are true and fair (Macdonald & Beattie, 1993:304-305).
The classical corporate governance model is illustrated in Table 2.3. (Macdonald &
Beattie, 1993:305). The model shows clearly that there is a practical separation
between the directors and shareholders. The separation between the directors and
between the two parties. The principle of corporate governance attempts in part to
bring the actions of directors and managers in line with the objectives of
in all companies, the conflict between directors and shareholders may remain.
TABLE 2.3.
CLASSICAL CORPORATE GOVERNANCE MODEL
Members Independent
auditors
Board of
directors
The business
non-equity
finance
Chapter 2 - A definition for dividends 40
The question has often arisen whether the shareholders of a company do not have
the right to declare dividends to themselves without the intervention of the directors
question.
If the shareholders of a company are given the right to calculate and declare
association, we find that new ground still has to be broken. Cases to discuss
scenarios where shareholders have gone to the Courts for reprieve against boards'
of directors who have not declared dividends to them, are rare in South Africa.
WLR 1068 (Ch) (Cilliers et al., 1992:356), a shareholder was denied the right to
receive dividends from the company even though it had profits available for
distribution. The Court, however, granted an order for the liquidation of the
company based on unfair and unreasonable conduct by the company. Section 344
(h) of the Act (South Africa, 1973) allows for a company to be wound up if it
appears to the Court that it is just and equitable that it be done. The said
shareholder would have only benefited via a liquidation dividend. Unfortunately a
number of uncertainties were highlighted in this case and final conclusions from it
"He has no property in, nor right to, any particular asset. He has only the
Chapter 2 - A definition for dividends 41
right to have all assets administered by the directors in accordance with the
constitution of the company, and his right to a dividend only arises when the
dividend is declared."
One would hope that the directors of a company would be given the opportunity in
each case to decide if, when and how much of a dividend should be declared and
paid to shareholders. The directors are indeed in the best position to make strategic
decisions about the re-investment of, or payments out of profit. These decisions
should be based on business risk management. It is the responsibility of the board
of directors of a company and its management to establish, maintain, operate and
display an appropriate framework of business controls and decisionmaking (KPMG,
1 995:97). These decisions are encompassed in the strategic management of an
organisation.
company is to earn a return on that investment. The long term strategic goals of the
Chapter 2 - A definition for dividends 42
company's board of directors and its management do not necessarily provide for an
immediate or high enough return from the perspective of the investor. The investor
and directors might have the same goals, but with different emphases and
timespans as long as the company and other shareholders are protected. It is, after
all, a shareholder's prerogative to hold any particular view on what he would want
from his investment. Rumpff, JA put it clearly in S v de Jager 1965 2 SA 616 (A)
shareholders to act in the interest of the company. The shareholders do not act as
'...[I]t also gives a general right to the company to distribute its assets to
capacity to it.
claims of creditors.
Neither shareholders nor directors nor the company itself can violate the
foregoing, whatever the memorandum or articles may say."
entrenched in their own visions for the companies which have employed them that
they rarely have had to worry about the shareholders of companies taking on
directors and the decisions that they have made. Activist shareholders in Europe are
starting to show enough strength to prove that shareholders rights are taking root
and flourishing in Europe. Both institutional and small shareholders are questioning
the decisions taken by directors. Although this tidal wave of shareholder revolts
should take a long time, European economists believe that a new generation of
directors will in time take over in the strong believe that corporate leaders are fully
accountable to shareholders (Anon., 1996:37 38). -
2.6.9. Conclusion
directors of a company have the right to determine whether, and how much of a
dividend should be paid to shareholders. South African Court cases are far from
Hopefully sanity will prevail so that directors will be given this responsibility.
directors of a company. In this, the needs of all stakeholders, not only the
the community in which a company operates and the state (KPMG, 1 995:5).
The needs of individual shareholders should further play second fiddle to the needs
by the directors of companies. Their appointment is, after all, in the hands of the
shareholders.
Chapter 2 - A definition for dividends 44
2.7. Summary
Various forms of literature have provided us with definitions for dividends. Accounting
literature is, however, lacking in defining dividends and dividend payments although the
act of declaring and paying dividends is standard practice for most companies.
The similarities in the definitions for dividends, bring us to the conclusion that dividends
may be defined as:
A payment, allocation or division of some form, sourced from profit and made to
Any company wishing to declare and pay dividends will be bound to a maximum legal
amount that is available for this purpose. The income statement of a company should be
used as the starting point for the resultant calculation as the income statement reflects the
accounting profit of the company. The determination of the maximum profit legally
available for declaration as dividends, is not a pure accounting decision or calculation, but
rather the calculation of profit legally available for distribution based on common law rules
for the payment of dividends and the capital maintenance theory. This calculation should
Consideration should be given to the nature or form of dividends that are to be paid once
The rules relating to the calculation of profit legally available for distribution as dividends
BIBLIOGRAPHY
ANON., 1 996: Mad as hell. Finance Week, June 6-12 1 996: 37-38.
BELKAOUI, AR 1 992: Accounting theory; third edition. London: Academic Press Limited.
CILLIERS, HS; BENADE, ML; HENNING, JJ; DU PLESSIS, JJ & DELPORT, PA 1992:
Korporatiewe reg; tweede uitgawe. Durban: Butterworths.
CILLIERS, HS; BENADE, ML; HENNING, JJ; DU PLESSIS, JJ; DELPORT, PA; FOURIE, JSA
& DE KOKER, L 1993: Entrepreneurial law: Durban: Butterworths.
COLLIER, PA; COOKE, TE & GLYNN, JJ 1988: Financial and Treasury Management.
Oxford: Heinemann Professional Publishing Ltd.
COOPERS & LYBRAND 1 995: Korporatiewe Bestuur. Die King-verslag; volume 1/95.
Johannesburg: Coopers & Lybrand.
DELOITTE & TOUCHE 1995: Directors' Duties And Corporate Governance. Gallo Manor:
Deloitte & Touche South Africa.
ELLIS, J & WILLIAMS, D 1 993: Corporate Strategy and Financial Analysis. London: oitman
Publishing.
FOSCHINI ANNUAL REPORTS 1995: 1995 Foschini Limited, Lewis Foschini Investment
Company Limited.
Chapter 2 - A definition for dividends 46
HENDRIKSEN, ES & VAN BREDA, MF 1 992: Accounting theory; fifth edition. Homewood:
IRWIN.
JOHNSON, THE 1 983: Investment principles; second edition. Englewood Cliffs: Prentice-
Hall Inc.
MACDONALD, N & BEATTIE, A 1 993: The Corporate Governance Jigsaw. Accounting and
Business Research, Volume 23 Number 91A Corporate Governance Special Issue
1993: 304-310.
PETER, L 1977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SOUTH AFRICA (Republic). Acts, statutes etc.: Income Tax Act (Act 58 of 1962 as
amended). Pretoria: Government Printer.
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973 as
amended). Pretoria: Government Printer.
STEWART, GB III 1 991: The Quest for Value. New York: HarperCollins.
THE CONCISE OXFORD DICTIONARY 1 982: seventh edition. Oxford: University Press.
THE INVESTORS' GUIDE 1996: Issue 77. The Johannesburg Stock Exchange.
Johannesburg: The Investors' Group (Pty) Ltd.
THE SOUTH AFRICAN BREWERIES LIMITED 1996: Annual report 101st year ending 31
March 1996.
VALENTINE, S 1995: Myngroep keer geen dividende uit nie. Sake-Beeld, 13 Desember
1995: S9.
VAN DORSTEN, JL 1993: The law of dividends in South Africa. Cape Town: Obiter
Publishers.
"To quote me the authority of precedents leaves me quite unmoved. All human
progress has been made by ignoring precedents. If mankind had continued to be the
slave of precedent we should still be living in caves and subsisting on shellfish and
wild berries." - Viscount Philip Snowden (Peter, 1977:290).
3.1. Introduction
The discussion in chapter 2 of this thesis led to the concliision that the maximum amount
that is legally available for distribution as dividends is not necessarily equal to the profit
reflected in the income statement of a company. Profit available for distribution as
dividends is rather a calculation based on profit in the income statement that is adjusted
for the effect of common law dividend rules that have evolved over time as a result of
Court cases on the matter of dividends.
In South Africa, the Companies Act (South Africa, 1973) does not reflect any of these
common law dividend rules and the Act does not provide for the manner in which profit
legally available for distribution as dividends is to be calculated.
The attitude of the Courts towards the calculation of profit available for dividends is set
out in a number of cases (Van Dorsten, 1 993:62).
In the case of Lee v Neuchatel 14.phalte Co (1889) 41 ChD 1 (CA) at 21, Lindley LJ said:
"There is nothing at all in the Acts about how dividends are to be paid, nor how
profits are to be reckoned; all that is left, and very judiciously and properly left, to
the commercial world. It is not a subject for an Act of Parliament to say how
accounts are to be kept; what is to put into a capital account, what into an income
account, is left to men of business."
In the case of Dovey v Cory [1 9011 AC 477 AT 488, Lord Macnaghten said:
"I do not think it desirable for any tribunal to do that which Parliament has
abstained from doing - that is, to formulate precise rules for the guidance or
Chapter 3 - Profit available for distribution as dividends 49
Although it might seem from the above extracts as if the Courts did not want to become
involved in determining profit available for dividends, they have not left the issue to
businesmen. Many a man has, after all, taken his plight over dividends to the learned men
of the Courts who have applied tried and tested principles in this regard.
The capital maintenance principal or "over-all-surplus" rule is one of the most important
principles applied by the Courts in South Africa in determining the amount of profit
available for dividends. The rule states that the legal profit of a company is the amount by
which a company's total assets exceed its nominal capital and reserves.
The capital maintenance rule is also the governing principle with regard to the payment of
dividends in European legal systems and is reflected in the Second EEC Directive of 13
except for cases where capital is legally reduced, no distribution should be made
to shareholders when the net assets of the company at year end are, or would be
lower than the company's subscribed capital and reserves following such a
distribution and
the amount of any distribution made to shareholders may not exceed the profits for
the year and any other reserves brought forward less any loss brought forward from
Although similar legislation does not exist in South Africa, the capital maintenance principle
one.
The principle of capital maintenance is one of the well known cornerstones of accounting
theory.
Chapter 3 - Profit available for distribution as dividends 50
The concept of capital maintenance is described as follows in AC 000 Framework for the
capital that it seeks to maintain. It provides the linkage between the concepts of
capital and the concepts of profit because it provides the point of reference by
enterprise's return on capital and its return of capital; only inflows of assets in
therefore as a return on capital. Hence, profit is the residual amount that remains
been deducted from income. If expenses exceed income the residual amount is a
net loss."
The above definition has given rise to several capital maintenance concepts that are used
to determine the goals to be attained in earning profit in a company. The two concepts that
are used in South Africa are defined as financial capital maintenance and physical capital
The financial capital maintenance theory explains that profit is earned by an organisation
if the financial or money value of net assets at the end of a period exceeds the financial
or money value of net assets at the beginning of the period, excluding any payment to or
contributions received from the owners of the organisation. Financial capital maintenance
on which the seventh common law dividend rule rests. The seventh common law dividend
rule will be discussed paragraph 3.11.
The physical capital maintenance theory dictates that profit is earned by an organisation
if the physical productive capacity of the organisation at the end of the period exceeds that
capacity at the beginning of the period, excluding distributions to or contributions from the
owners of the organisation. Other than financial capital maintenance, all price changes
affecting the assets and liabilities of the organisation are viewed as changes in the
Chapter 3 - Profit available for distribution as dividends 51
measurement of the physical productive capacity of the organisation that is treated as part
Generally, the payment of dividends would stem from profit earned from the financial
capital maintenance theory. The financial capital maintenance theory puts forward the idea
that a company could earn profit (holding gains) through simply holding assets, without
power. The profit would result from an increase in the value of the assets due to an
increase in general price levels that goes hand in hand with inflation. The effect of inflation
on dividends is discussed in paragraph 4.8. Increases in assets, are one of the sources of
Because no legislation currently exists in South Africa to enforce capital maintenance, nor
any legislation to dictate how profit available for distribution as dividends should be
calculated, the common law rules for the calculation of profit available for distribution as
Eight common law rules have evolved over time from Court cases heard on the matter of
dividends. As stated in paragraph 2.4.4. accounting profit is the starting point for the
calculation of profit legally available for the payment of dividends. For this purpose,
accounting profit is adjusted by the effect of the principles laid down in the common law
dividend rules.
The following common law rules apply in the calculation of profit available for the payment
Rule Rule:
number:
1. Dividends may not be paid out of the paid up share capital of a company as
Dividends may be paid out of profit for the year. Accumulated losses
suffered in past trading periods do not have to be taken into account when
determining profit available for legal distribution (discussed in paragraph
3.6.).
Provision for losses in fixed capital and depreciation of fixed capital may be
ignored in the calculation of profit available for legal distribution (discussed
in paragraph 3.7.).
Similar rules are applied in the United States of America. The legality of dividend payments
in the United States of America are determined by reviewing applicable state laws. Where
the law in that country is not clear, accounting literature directs accountants to the Courts
3.5.1. Introduction
The first common law rule for the declaration of dividends, states that dividends
may not be paid out of the paid up share capital of a company as contributed by the
members.
The idea that the paid up share capital of the company has to be maintained at
The capital maintenance theory implies that income should only be recognized after
these principal concepts to the theory were discussed in paragraph 3.3. The
conclusion of this discussion was that financial capital maintenance was the
appropriate theory under review for the study of the payment of dividends as
financial statements are still largely prepared on an accrual basis. Profit forthcoming
from financial capital maintenance can be defined as the maximum amount that can
be distributed to the shareholders of a company (Wolk, Francis & Tearney,
1992:30).
The Courts have taken the view that a company's paid up share capital should be
protected in order to secure a fund that creditors can turn to on default of the
company. In the words of Cotton LJ in Guinness v Land Corporation of Ireland
(1882) 22 ChD 349 (CA) 375 (Cilliers et al., 1992:347):
"...[Clapital cannot be diverted from the objects of the society. It is of
course liable to be spent or lost in carrying on the business of the company,
but no part of it can be returned to a member so as to take away from the
Chapter 3 - Profit available for distribution as dividends 54
fund to which creditors have a right to look as that out of which they are to
be paid."
The prohibition against paying dividends out of paid-up capital is, therefore, rather
a prohibition against the positive misuse of the capital funds of a company, than the
et al., 1992:347).
The benchmark South African case regarding capital maintenance is that of Cohen,
N.O. v Segal 1970 3 SA 702 (W) 702-07, in which the now famous Judge Richard
Goldstone appeared for the plaintiff. The facts of this case were that the sole
directors and shareholders of the Johannesburg Timber Co. (Pty) Ltd, Mr. Segal and
Mr. Harber had, prior to it's liquidation, sold the company's fixed property. They
then divided the proceeds of the sale between them by debiting their loan accounts
dividends to cancel out their loan accounts. The liquidator of the company sued Mr.
Segal for the pecuniary loss which the company had sustained as a result of the
delict. The liquidator instituted action for a refund of the sum of money as there
were no profits at all from which a dividend could be declared. The deficiency in the
assets at the time of the dividend declaration was R4 390. Surely a sufficient sum
of money to approach the Courts with in 1970. The judge in the case, Boshoff, J
a dividend is declared;
the capital contributed by a member cannot be returned to him and no part
of the body of the company can be returned to a member and taken away
from the fund to which the creditors have a right to look at as that out of
Any shortfall or deficit in the paid-up equity of the company, before or after a
dividend payment should, therefore, first have to be neutralised before such a
payment can be made. Once this objective has been achieved, both the judicial and
accounting capital maintenance theories will be met.
The Act (South Africa, 1 973) allows for a number of exceptions to the rule that the
paid-up share capital of the company should be maintained.
With regards to dividend payments, the first exception relates to the case of a
company where shares are issued at a premium, and a share premium reserve
account is created in the records of the company. This share premium reserve is
one of the non-distributable elements of equity in the balance sheet.
One of the uses for this reserve is the paying up of unissued shares of the company
to be issue to the members of the company as fully paid up capitalization shares as
stated in section 76 (3) (a) of the Act (South Africa, 1973). The capitalization
shares are regarded as a form of dividend payment as stated in paragraph 2.3. as
such an issue provides an investor with a form of return on his investment.
Capitalization shares are discussed in chapter 7 of this thesis.
The Act (South Africa, 1973) allows for a number of other legal reductions of share
capital. Section 76 (3) also allows for the following that may be written off against
the share premium account:
the preliminary expenses of the company and
the expenses of, or the commissions paid or discount allowed on, creation
Chapter 3 - Profit available for distribution as dividends 56
Further legal reductions of share capital relates to the capital redemption reserve
fund. The capital redemption reserve fund created on the redemption of redeemable
preference shares out of profits which would otherwise have been available for
dividends may be used for the purpose set out in section 98 (4) of the Act (South
Africa, 1 973). This section states that the capital redemption reserve fund may be
applied by the company in paying up unissued shares of the company to be issued
to the members of the company as fully paid-up share capital.
The issue of shares of no par value will be accounted for in the stated capital
account. In terms of section 77 (3) of the Act the stated capital account may be
used in writing off the preliminary expenses of a company or the expenses of, or
the commission paid on, the creation or issue of shares of no par value (South
Africa, 1973).
The capital of a company may, generally, also be reduced from time to time if the
company complies with section 84 and 85 of the Act (South Africa, 1 973).
3.5.5. ConcOusion
The view that dividends may not be declared out of the paid up share capital of a
company is underwritten by both accountants and the Courts. Both groups want
the capital of a company to remain intact. This will create a guaranteed fund to
which creditors can turn and is a prerequisite for distinguishing between an
The return earned on capital is a measure of the success of a company. The return
of capital will reflect a decrease in the permanent funds of a company. The
resources of the company will, therefore, diminish. In order to measure whether a
company is successful in maintaining a resource base, investors may calculate a
Return on capital is normally calculated for ordinary shareholders as they are the
group of investors who carry the major risk in any company.
The importance of the ratio can be seen from the two formulas derived from it as
described in Table 3.1.
TABLE 3.1.
RETURN ON CAPITAL FORMULA
The net profit margin and asset turnover which is derived from the ratio return on
capital employed are two of the important ratios calculated in financial statement
analysis. These ratios are classified as profitability ratios. Profitability ratios are
intended to show the combined effect of liquidity, asset management and debt
management on operating results (Correia, Flynn, Uliana & Wormald, 1 989: 1 54).
Companies are, however, not guaranteed profitability and may accumulate losses
over time.
Chapter 3 - Profit available for distribution as dividends 58
3.6.1. Introduction
The second common law dividend rule states that dividends may be paid out of
profit for the year, whilst accumulated losses suffered in past trading periods do not
have to be taken into account when determining profit available for legal distribution
as dividends. The results of each of the trading periods of the company is
considered separately in the payment of dividends. If previous losses are ignored
it means that losses in previous trading periods do not have to be made up or
equalised by profits earned at a later stage before dividends, whether ordinary or
preference dividends, are paid. Dividends may be paid as soon as current profits are
earned.
Although this rule is particularly advantageous to the investor, the question should
be asked whether the principle is based on sound accounting theory. If accumulated
losses are ignored by the Courts, one would hope that accountants would also view
it as of no consequence based on the conceptual nature of accumulated losses.
Accumulated losses may appear as a line item in the balance sheets of companies.
AC 000 Framework for the preparation and presentation of financial statements
states that the elements directly related to the measurement of the financial position
of a company in the balance sheet are assets, liabilities and equity (SAICA,
Chapter 3 - Profit available for distribution as dividends 59
Assets are defined as resources that are controlled by a company as a result of past
events and from which future economic benefits can be expected to flow (SAICA
1990:par.49). AC 000 Framework for the preparation and presentation of financial
statements states that the future economic benefits of assets are embodied in the
contribution that the assets can make to the flow of cash and cash equivalents to
a company (SAICA, 1990:par.53). These benefits should flow directly from the
assets. Accumulated losses could, at most, lead to assets flowing into a company.
This flow would stem from the fact that investors would be prepared to invest in
a company with accumulated losses given the fact that it is currently returning
profits. Past losses could then be ignored in the payment of future dividends. As
accumulated losses are, at most, of indirect benefit to a company, accumulated
losses can not be classified as assets.
Equity is defined as the residual interest in the assets of a company after deducting
its liabilities. Equity may be divided into further categories such as funds contributed
by shareholders, retained earnings and reserves (SAICA, 1990:par.49,65). Any
income not distributed among the shareholders, therefore, becomes additional
shareholders' equity. The more common items that either increase or decrease
retained earnings are expressed in T-account form in Table 3.2. (Kieso & Weygandt,
1986:659):
Chapter 3 - Profit available for distribution as dividends 60
TABLE 3.2.
T-ACCOUNT - RETAINED EARNINGS
DR RETAINED EARNINGS CR
_
Net losS Net income
Prior period adjustments and certain Prior period adjustments and certain
changes in accounting principles changes in accounting principles
The nature of accumulated losses is, therefore, that it forms part of the equity of
a company, just as retained earnings would fall into this category. Accumulated
losses will be classified as the negative component of equity.
Accumulated losses and retained earnings are in essence two sides of the same
coin. The coin being one form of the distributable equity of a company. The equity
of a company consists of capital (that may not be reduced) and other reserves, both
distributable and non-distributable in nature. The effect of accumulated losses on
the capital of a company that has to be maintained at all times, should be
investigated further.
a company in various forms and the two statutory non-distributable reserves being
the share premium account and the capital redemption fund (Cilliers et al.,
1992:198).
negative impact on, or lessening of its capital or equity. Accumulated losses would
erode the capital fund of a company and capital consequently cannot be maintained.
Any profit earned by a company in a trading period after suffering net losses in
previous trading periods should, therefore, be utilised to return the capital of the
company to its former levels. Any distribution from such profits would delay the
maintenance or return of capital. The principles behind the second common law
dividend rule is, therefore, completely opposite to the capital maintenance theory
applied by the Courts in setting the first common law dividend rule. Capital is
maintained by the application of the first common law dividend rule, but not by the
second rule.
One would have expected the two sides of the distributable equity coin, being
accumulated losses and retained earnings, to be treated equally by the Courts. This
is, however, not the case. Accumulated losses from previous years may be ignored
in the payment of dividends. Retained earnings from previous years may be utilised,
for among others, the payment of dividends. The question remains why the Courts
have applied different principles to different aspects of equity or capital. The Courts
have given recognition and importance to every part of equity, except its negative
a non-entity.
reason why it should not have to be made up for in following accounting periods
for the purpose of paying dividends. Although accountants can, generally, utilise
retained earnings in many ways, but are yet to find one useful purpose for
accumulated losses it has not distracted them from accounting and disclosing
accumulated losses.
The capital maintenance theory was probably not the only factor considered by the
Courts in defining this second common law dividend rule. Other accounting issues
such as the division of the results of a company into different periods probably also
Chapter 3 - Profit available for distribution as dividends 62
One of the bases on which the Courts have allowed accumulated losses to be
ignored in the calculation of dividends, is the fact that the accounting periods of a
company should be regarded separately.
The division of the business activities of a company into cycles or periods is backed
up by two accounting postulates documented by Maurice Moonitz (Zeff,
1982:par.52-53, study 1). These postulates are defined as follows:
"Postulate A-4:
Economic activity is carried on during specifiable periods of time. Any report
on economic activity must identify clearly the period of time involved.
Postulate 8-4:
The results of operations for relatively short periods of time are tentative
whenever allocations between past, present, and future periods are made."
Periods in which losses are realised are distinguished from periods of equal length
in which profit is earned. This basis of distinction in formulating the second
common law dividend rule is acceptable to accountants.
From the perspective of an investor, the second common law dividend rule provides
him with a successful opportunity to earn a return on his investment. This will be
the case if the company in which he has invested has succeeded in turning a
negative financial position around to pay dividends, without making up for previous
losses.
One of the earliest listings on the Johannesburg Stock Exchange that is still in
Chapter 3 - Profit available for distribution as dividends 63
existence, is Usko Limited (Unie Staal Korporasie van Suid-Afrika), listed in 1911.
The activities of this group of companies comprise the manufacture and sale of
copper wire and strip, electric cable, aluminium wire, strip and conductor and
stainless steel. After a protracted decline in it's activities, the groUp sold its
stainless steel business and restructured the companies loans and capital in order
to avoid liquidation. Shareholders who were previously loan creditors accepted the
restructuring on the basis that they would receive dividends on their converted
loans, that is now share capital. As Usko Limited managed to turn their business
around to some extent, regular dividend payments were possible because prior
losses were ignored in line with the common law principle. This has guaranteed the
survival of the company. To show the effect of the rule, the relevant financial
information has been extracted from the audited annual financial statements of
Usko Limited for the year ending 30 September 1993 (Usko Limited, 1993:14).
TABLE 3.3.
USKO LIMITED PROFIT HISTORY .
ACCUMULATED LOSS AT PROFIT FOR THE YEAR DIVIDENDS PAID PER INCOME
BEGINNING OF YEAR AFTER EXTRAORDINARY STATEMENT
ITEMS, BUT BEFORE
DIVIDENDS
Retained earnings
for the year R 87k
Retained earnings
for the year R 4 806k
3.6.7. Condusion
Accumulated losses form part of the equity of a company. Although such Fosses
has no direct purpose and cannot be utilised for any productive means it has to be
The Courts have erred in suggesting that accumulated losses may be ignored in
calculating profit available for distribution as dividends. It goes against the capital
maintenance theory subscribed to by accountants and the Courts in defining the
first common law dividend rule. The correct implementation of the division of the
results of a company into accounting periods which was also considered by the
Courts, have been nullified by the lack of capital maintenance in the application of
the rule. The only group that may benefit in part from the•implementation of the rule
is investors in certain shares. Those investors are provided with an opportunity to
earn a return on their investments as soon as the company generates profit. The
risk profile of such shares will, however, increase as the confidence in the company
deteriorates as the capital fund is eroded.
With reference to the position in other countries as set out in paragraph 3.13, this
second common law dividend rule that is applied in South Africa is far behind the
rest of the accounting world.
3.7.1. Introduction
The Courts have, in determining the third common law dividend rule, stated that
dividends may be paid out of profits without first making good losses on fixed
assets that are described as, losses in respect of fixed capital. Neither does one
need to take depreciation of fixed assets described as fixed capital into account
before paying dividends. The effect is to add the provision for losses on fixed assets
and depreciation of fixed assets to accounting profit (or to deduct it from
accounting losses) for the year in order to calculate profit available for distribution
as dividends.
The rule was applied in the case of Ammonia Soda Company Limited v Chamberlain
The nature of the terms "fixed capital", "losses" and "depreciation" needs further
attention in determining what exactly is to be ignored in the application of the rule
as particularly "fixed capital" and "losses on fixed capital" are not terms that are
generally used by accountants..
The Courts have commonly referred to the terms "fixed capital" and "floating or
circulating capital" as assets of a company that may be transferred. The terms are
used to identify the assets of a company in which the capital funds are invested
(Cilliers et al., 1992:350). The nature of fixed capital was discussed in a number
,
of Court cases.
In Verner v General & Commercial Investment Trust [1894]2 Ch 239 (CA) at 265,
Lindley LJ stated the following:
"There is no law which prevents a company from sinking its capital in the
purchase or production of a money-making property or undertaking, and in
dividing the money annually yielded by it, without preserving the capital
sunk so as to be able to produce it intact either before or after the winding-
up of the company" (Van Dorsten, 1 993:70).
Chapter 3 - Profit available for distribution as dividends 66
A loss resulting from a fire or any similar occurrence that has destroyed a whole or
part of an asset is not the type of loss that the Courts have referred to in defining
the third common law dividend rule. Such losses are recognised in the income
statement as and when the losses occur. Losses that have an immediate and direct
effect on the possibility of the company to make a profit through the use of an
asset has to be accounted for at that time and has to have an effect on profit and
profit available for dividends. It is, after all, fully realised.
The statement of the Courts, refers rather to a provision for losses reflected in the
balance sheet and not a realised expense deducted directly from profit. It is,
therefore, closely related to the loss or cost of an asset provided for through the
normal depreciation charge in the income statement and accumulated depreciation
provision in the balance sheet of a company.
There are a number of relevant Court cases to back up this view (Cilliers et al.,
1992:349). In Lee v Natal Land and Colonization Company [18921 2 Ch 124 the
ruling was made that a decrease in the value of land should not be taken into
account in determining profit available for distribution. In Verner v General and
Commercial Investment Trust [189412 Ch 239 it was decided that a company may
pay dividends out of profit before depreciation on investments held as fixed assets
is taken into account. In Re Kingston Cotton Mill Co (No 2) [189611 Ch 331 and
[1896] 2 Ch 279 (CA) the development of the rule was concluded when it was
Chapter 3 - Profit available for distribution as dividends 67
The third dividend rule can now be simplified by saying that depreciation on fixed
assets may be ignored in the calculation of profit available for distribution as
dividends.
One presumes that the Courts had a specific view of depreciation in mind when
deciding to ignore depreciation in the calculation of profit available for distribution.
In order to evaluate whether the Courts' decision is sound from a conceptual
accounting point of view, one has to investigate the nature of each of the three
views of depreciation and its relevance to the Courts' decision.
item should be allocated on a systematic basis over the useful life of the
asset in such a way that the depreciation method should reflect the pattern
123 Property, plant and equipment applies to all property, plant and
equipment (SAICA, 1 994a:par.03).
cost of an asset to each accounting period during the expected useful life
of that asset.
It is unlikely that the Courts held this view of depreciation, as this view
would have led them to the conclusion that depreciation should be taken
into account in determining profit available for distribution as dividends as
depreciation is regarded as an expense or cost allocation. It appears as if the
Chapter 3 - Profit available for distribution as dividends 69
This particular view is not taken too seriously by accountants as, among
others, the depreciation charge will be subjective, and the effect of inflation
not necessarily taken into account in the determination of depreciation.
None of the Court cases relating to this common law rule have indicated that
the Courts saw depreciation as a valuation tool. As this view of depreciation
is not backed up by accounting principles, it is also not acceptable as a basis
for the common law rule.
The physical capital maintenance theory was probably not considered by the
Courts. The Courts have generally steered away from the advanced capital
maintenance theory as discussed in paragraph 3.5.2. Moreover, if the Courts
had accepted this theory, they would not have allowed accountants to
ignore depreciation in dividend calculations, as capital would not have been
maintained in that case.
3.7.4.4. Conclusion
AC 123 Property, plant and equipment concurs with this view in stating that
the depreciable amount of an item of plant, property or equipment should be
allocated on a systematic basis over the useful life of an asset (SAICA,
1 994a:par.44).
Based on the principles laid down in the above mentioned literature, the
made between depreciation and other expenses and there is, therefore, no
reason why depreciation should be ignored and other expenses taken into
If the Courts saw depreciation in a sound conceptual light, they would surely
also have concluded that it has some substance and importance just as
company.
To get a perspective on the amounts involved in applying this rule and how it could
come to the rescue of a company that is desperate to pay dividends, one needs to
Table 3.4.
TABLE 3.4
DEPRECIATION V DIVIDENDS
In each of the above cases, the depreciation charge in the income statement
covered the dividend payments made. If this trend is taken as the usual occurrence,
it would follow that this rule can be extremely useful for companies who intend
paying dividends that are not necessarily matched by accounting profits for a year.
3.7.6. Conclusion
The view of the Courts that depreciation should be ignored in the calculation of
profit available for the payment of dividends, is not defendable based on accounting
principles and is conceptually rather outdated and unsound.
With reference to the position in other countries as set out in paragraph 3.1 3., the
third common law dividend rule that is applied in South Africa is far behind
legislation in the rest of the accounting world. Most European countries have
legislated this common law rule out of use. Recommendations on how to deal with
this issue in the South African environment are detailed in chapter 9.
The fourth common law dividend rule states that losses and depreciation on circulating or
working capital should be taken into account in determining profit available for distribution
as dividends.
Once again the Courts have used a somewhat unfamiliar term to South African
accountants being circulating or working "capital".
Chapter 3 - Profit available for distribution as dividends 73
As discussed in paragraph 3.7.2. when the Courts refer to capital in the matter of
dividends, they refer to assets, in this case circulating or working assets. Another synonym
for circulating or working capital is current or flowing assets.
The difference between fixed and circulating capital is explained by Lord Haldane in the
case of John Smith v Moore (192112 AC 13, 19-20 (Cilliers et al., 1992:350):
"Adam Smith described fixed capital as what the owner turns to profit by keeping
it in his own possession; circulating capital is what he makes a profit of by parting
with it and letting it change master."
The meaning of the term "circulating" capital was discussed in the case of Ammonia Soda
Company Limited v Chamberlain [1918] 1 Ch 266 (CA) at 286 (Van Dorsten, 1993:73)
Thus the capital with which a trader buys goods circulates; he parts with it, and
with the goods bought by it, intending to receive it back again with profit arising
from the'resale of the goods. A banker lending money to a customer parts with his
Money, and thus circulates it, hoping and intending to receive it back with interest.
He retains, more or less permanently, bank premises in which the money invested
becomes fixed capital. It must not, however, be assumed that the division into
which capital thus falls is permanent. The language is merely used to describe the
purpose to which it is for the time being appropriated. This purpose may be
changed as often as considered desirable, and as the constitution of the bank may
allow. Thus bank premises may be sold, and conversely the money used as
circulating capital may be expended in acquiring bank premises. The terms "fixed"
and "circulating" are merely terms convenient for describing the purpose to which
the capital is for the time being devoted when considering its position in respect to
the profits available for dividend."
Chapter 3 - Profit available for distribution as dividends 74
The nature of circulating or current assets is such that it is generally fully realised in cash
or sold or consumed during the normal operating cycle of a business (Hendriksen & Van
Breda, 1992:559). Losses or depreciation on such assets will follow suit. Depreciation and
losses should prudently be subtracted from accounting profits or added to accounting
losses for a period in the income statement and should consequently reduce the profit
available for the payment of dividends. Any well drafted income statement should already
This, the fourth common law dividend rule is certainly one of the less complicated common
law dividend rules where the Courts and accountants easily agree conceptually.
Similar to the previous rule, the fifth common law dividend rule which states that realised
profits on the sale of fixed assets may be distributed, does not pose any major problem.
The Oxford Dictionary (The Concise Oxford Dictionary, 1 982:862) defines "realised" as
converted into fact, to present as real, conceive as real, convert into money and
apprehended clearly.
At the point of realisation, income can be recognised. Income that has been recognised,
is there to be utilised in any way that the directors of the company see fit. Neither the
Courts nor accountants should have a problem with declaring realised profits as dividends.
The view also conforms to the requirements of the prudence concept discussed in AC 101
Disclosure of accounting policies. The prudence concept requires that revenue and profits
are recognised in the income statement of a company only when realised in the form of
Chapter 3 - Profit available for distribution as dividends 75
cash or of another asset the ultimate cash realisation of which can be assessed with
The only restriction on the application of the fifth common law dividend rule might be that
the articles of association of a company could prohibit the distribution of profits that have
been realised on the sale of fixed assets. If such a stipulation exists, neither the Courts,
The sixth rule states that unrealised profits on the revaluation of circulating or working
capital may be distributed. Again, the term "circulating capital" refers to current assets as
Depending on the type of business and the length of its cycles, it is generally expected that
the profit on circulating assets or current assets of a company will be realised within the
it would not be necessary for a company to declare dividends from unrealised profits on
current assets, as revenue from the sale of current assets would be realised in a fairly short
period, generally within 12 months of acquiring the assets. A short delay in the time of the
revenue recognition and the consequent declaration of profit on the transaction at a later
stage should not have a serious negative effect on the business plan implemented by the
directors of a company as they may declare interim dividends at any time in any given
financial year.
Companies such as those involved in town development projects where profits on the sale
of current assets could be realised in a period longer than one year are the only entities
that might want to declare dividends out of unrealised profits on current assets (Cilliers et
al., 1992:352).The Act, however, provides for a more prudent option for such companies.
Companies such as town developers wishing to declare some form of dividend or interest
on its capital may rather do so via section 79 of the Act (South Africa, 1973) which allows
for the payment of interest on capital invested if companies comply with the specific rules
Chapter 3 - Profit available for distribution as dividends 76
The requirements of section 79 of the Act (South Africa, 1 973) are as follows:
resolution and
the payment should not extend past the six months after the half-year during which
the works or buildings have actually been completed or the plant provided and
the rate of interest shall not exceed six per cent per annum or such lower rate as
Although allowed by common law, other companies wishing to pay dividends from
unrealised profits on the revaluation of current assets should consider the issue
conceptually.
Whilst the revaluation of the current assets could be of a permanent nature and done in
good faith, the profits from the revaluation has not yet been realised.
AC 111 Revenue (SAICA, 1994b:par.16) dictates that revenue from the sale of goods, in
other words stock as part of current assets, should be recognised when all five the
the significant risks and rewards of ownership of the goods have been transferred
usually associated with ownership nor effective control over the goods sold;
when it is probable that the economic benefits associated with the transaction will
Based on the above criteria for the recognition of revenue, the declaration of unrealised
profits on the revaluation of current assets as dividends is directly against the first four
criteria set for recognition. If revenue is not recognisable, it may certainly not be declared,
Chapter 3 - Profit available for distribution as dividends 77
as dividends.
It would hardly be prudent or conceptually sound for any company to make dividend
payments from unrealised profits on the revaluation of current assets. Particularly if
directors are grabbing at the last straws of survival in order to label a company as one
providing a regular dividend return for its investors.
3.11.1. Introduction
Being one of the more interesting common law dividend rules, the seventh was
conceived much later than some of the other rules (Cilliers et al., 1992:352). In the
Dimbula Valley (Ceylon) Tea Co v Laurie [1961]1 All ER 769 (Ch) case, the learned
judge decided that reserve funds from the revaluation of unrealised fixed assets
may be distributed as dividends if:
the articles of association allows such a distribution;
the increase in the valuation of the fixed assets is permanent and has not
occurred as a result of a short term fluctuation and
the valuation was done in good faith by a competent valuer.
et al., 1992:352).
3.11 .2. Case law and other views against the distribution of
unrealised profit on the revaluation of fixed assets
Two of the presiding judges in the Scottish case of Westburn Sugar Refineries Ltd
The Main Report of the Van Wyk De Vries Commission of Enquiry of 1970 into the
Companies Act made the following similar recommendation which was never
implemented into law:
"In the case of Westburn Sugar Refineries Ltd v Inland Revenue
Commissioners (1 986) SLT 297, it was decided that such a surplus was not
distributable. However, the case of Dimbula Valley (Ceylon) Tea Co Ltd v
Laurie (1961) Ch 353 decided the opposite. The Dimbula case has not so
far, it seems, been considered by the courts in South Africa. From the
Jenkins Report (paragraph 337) it appears that the evidence laid before that
Committee has strongly opposed the proposition that an unrealised surplus
arising on revaluation of fixed assets should be available for distribution as
a dividend. We have received similar evidence and on principle we agree that
such surpluses should not be available for distribution. It seems desirable to
settle the law on this point.... We recommend: that Schedule 8 be amplified
to clarify that an unrealised surplus arising on the revaluation of fixed assets,
should not be directly or indirectly available for distribution as a dividend "
(Van Dorsten, 1993:76).
The rule, as set in the Dimbula Valley (Ceylon) Tea Co v Laurie (1961) Ch 353
which was discussed in paragraph 3.11.1. have also been recognised by the
accounting standards.
Chapter 3 - Profit available for distribution as dividends 79
continuous by saying that it is widely accepted that revaluation surpluses are not
available for distribution until the profit is realised. It is interesting to note that the
Schedule 4 of the Act (South Africa, 1973) refers to the rule in an indirect way.
Paragraph 42 (c) requires that the following be disclosed in the financial statements
of a company:
that effect".
The guideline states that a significant element of the objective of the revaluation of
fixed assets is to eliminate one of the main distortions that arises in financial
Chapter 3 - Profit available for distribution as dividends 80
AC 202 Accounting for fixed asset revaluations is quite emphatic in its view on the
distributability of the unrealised surplus on the revaluation of fixed assets. It is
stated clearly in paragraph .08 that:
"An unrealised surplus is not regarded as being available for distribution until
realised" (SAICA, 1983).
Property, plant and equipment which deals in part with the revaluation of assets
(SAICA, 1 994a). As AC 123 Property, plant and equipment forms part of the
accounting standards rather than the guideline status afforded AC 202 Accounting
for fixed asset revaluations (SAICA, 1 983). AC 123 Property, plant and equipment
would be the more important accounting statement to consider with regards to
revaluing assets.
Paragraph .41, .42 and .43 of AC 123 (South Africa, 1994a) discusses the effects
statement."
both AC 202 Accounting for fixed asset revaluations and AC 123 Property, plant
and equipment clearly professes that the surplus on the revaluation of assets may
The first being the issue of capitalization shares to shareholders sourced from the
revaluation reserve. The second being that transfers can be made from the
revaluation reserve to the deferred taxation account, but that it should not exceed
the taxation payable on the revaluation reserve remaining in the non-distributable
reserve for that particular asset. The third is to apply surpluses on revaluations
against deficits, where the surplus or deficit reverses the position that arose on a
Previous valuation. No mention is made of any other way in which the unrealised
surplus can be utilised (SAICA, 1983:par.17).
AC 123 Property, plant and equipment indicates that the revaluation surplus may
be utilised in two ways (SAICA, 1994a:par.43). The first being on realisation of the
asset. Although realisation is not defined specifically in AC 123 Property, plant and
equipment, realisation in terms of accounting literature is the point where the asset
The other option is that the realisation of the reserve takes place over time as the
asset is used. The value of the realisation would be the difference between
depreciation based on the revalued carrying amount of the asset and depreciation
Conceptually, the sound accounting option that companies may utilise if they wish
Chapter 3 - Profit available for distribution as dividends 83
depreciation on the cost of the asset and to transfer this amount directly to the
income statement. There is no prohibition against a once-off transfer to the income
statement to catch up on depreciation differences so realised. The legality of the
distribution of the gross amount of depreciation on the revalued asset may,
however, be in doubt, so too declaring the entire revaluation reserve as dividends.
There is no doubt that a revaluation reserve should be created at the time of the
revaluation of a fixed asset. The new AC 123 Property, plant and equipment
confirms that when an asset is revalued, the increase should be credited directly to
equity under the heading of "revaluation surplus" (SAICA, 1 994a:par.411.
If the common law rule on the distribution of this reserve is applied in practice,' it
follows that the relevant portion of the revaluation reserve has to be transferred to
the income statement for use as a distributable reserve to be paid out in the form
of dividends. Such a transfer can only be illegal if it is stated as such in the Act.
According to the Act, the only non-distributable reserves that may not be converted
to distributable reserves, are the share premium account per section 76 and the
capital redemption reserve fund per section 98 (South Africa, 1 973). The use of the
non-distributable reserve on the revaluation of fixed assets is not prohibited by the
Act but only by the accounting concepts of "realisation" and revenue recognition.
The accounting views against dividend payments from revaluation reserves, has not
prevented companies from practically applying this common law dividend rule.
3.11.7.1. Intvoduction
Koos Jonker, half-brother of the famous, but tragic poet, Ingrid Jonker, had
a dream that came into fruition in 1985 when he started a company called
Masterbond Properties. He started this venture after he left the employ of
the Owen Wiggens Trust. The primary incarnation of the Masterbond group
was Club Mykonos, a sundrenched Mediterranean type holiday resorts for
the affluent near Langebaan on the Cape West Coast. Property prices were
in Jonker's favour at the time and he started to interest investors with
returns on participation bonds and short term debentures that were markedly
higher than those offered by other institutions. The company rapidly
expanded into ventures such as Fancourt, Phinda Game Lodge, Pretoria Bank
and Marina Martinique. Masterbond's agents sold millions of Rands of high-
risk participation mortgage bonds and short-term debentures to investors
who were mainly pensioners. As the company began to tackle too much, its
resources were stretched to breaking point. To meet major cash shortfalls,
the group began to increase capital internally, based on inflated property
valuations. These assets in turn attracted new investments from the public
that was immediately channelled into other haemorrhaging holes like the
companies' interest bills to existing investors that was rapidly outstripping
the companies' ability to attract fresh capital. Meanwhile, the leisure
industry (on which the Masterbond group was heavily reliant) lacked real
substance, making the group's investment value an ephemera. Jonker and
Masterbond eventually faced a black hole with thousands of mostly older
The curators of the Masterbond group released six reports of about 500
pages since its collapse (West, 1 995a:2). Since liquidation, investors have
been repaid R427million or 69% of the total R617million debt to investors.
Of the remaining R190million, liquidators expect to retrieve R80million
(West, 1995b:1).
One of the instances where the group used this seventh common law rule
to the detriment of the group and its investors was the case of Masterbond
Properties and one of its subsidiaries, Methyr Properties. Methyr Properties
revalued its only asset, being a property in Pinetown in Kwazulu-Natal, by
about R3,4million more than the previous bond value in August 1989. At a
from an Ernst & Young partner, David Moir, that such a distribution was
legally allowed. Judge Nel pointed out that the Masterbond group evaded
tax in this case by distributing the reserve in the form of a dividend. The
commission questioned whether the investors would have known that the
interest payment on their investment was in fact income derived from the
the Masterbond group are currently also taking steps against Mr. Andre
to himself and his family in the form of dividends when this company did not
It has been argued that the distribution of unrealised profits on the revaluation of
fixed assets is against accounting practice in terms of AC 123 Property, plant and
The following are a number of facts that should be considered (Van Dorsten,
1993:77):
the Dimbula Valley case remains persuasive when considering the legality
of such a distribution.
should, however, change presently as draft legislation has been prepared to change
Chapter 3 - Profit available for distribution as dividends 87
the position.
The auditor, considering these facts, may refer to AC 202 Accounting for fixed
asset revaluations and AC 123 Property, plant and equipment if his client wishes
to distribute an unrealised profit on the revaluation of fixed assets as dividends. The
common law rule, however, remains in place and scenarios such as the Masterbond
case will continue regardless of the accounting view that is generally accepted. As
With Masterbond investors, the general public will be worse off in such a scenario.
Again, prudence and revenue recognition is ignored by companies wishing to
maintain a particular reputation in the marketplace.
3.12.1. Intvoduction
The eighth and last common law dividend rule for the calculation of profit available
for distribution, simply states that the financial position of a company as a whole
should be considered and not only individual transactions, before dividends are paid
to investors. The solvency and liquidity of a company before and after a dividend
payment is made should, therefore, be considered (Cilliers et al., 1 992:348-349).
Byrne J summarised the common law rule in the case of Foster v New Trinidad Lake
Asphalt Co Ltd [1901]1 Ch 208 at 212-213 (Cilliers et al., 1992:348):
"...[T]he question of what is profit available for dividend depends upon the
result of the whole accounts fairly taken for the year, capital, as well as
profit and loss, and although dividends may be paid out of earned profits in
proper cases, although there has been depreciation of capital, I do not think
that a realised accretion to the estimated value of one item of the capital
assets can be deemed to be profit divisible amongst the shareholders
Both accountants and the Courts have to agree on the validity of this rule based on
Chapter 3 - Profit available for distribution as dividends 88
prudence, solvency and liquidity demands. Any company wishing to make use of
any of the other common law dividend rules, should make sure that they also apply
this, the eighth rule.
The public demands that auditors consider whether directors have applied the going
concern concept in the process of preparing financial statements (Percy, 1995:28).
Any company wishing to make a dividend payment to its shareholders that may
compromise the solvency and liquidity of that company, may still do so at its own
choice. The consequence would probably be that the auditors of a company would
qualify the audited annual financial statements if the amount is material.
This is good and well for the educated investor, but in most cases investors, on
receiving the financial statements of the company, would probably miss the very
important point that the financial statements have been qualified. Furthermore, even
if these investors have not received the audited annual financial statements of the
company, they would probably not understand the consequences of the "Q"
classification of such a company, given to it by the Johannesburg Stock Exchange
(refer to paragraph 3.1 2.3). The uneducated investor would probably be very happy
with his investment as he has received dividends creating the impression that the
business is being run well.
on the prices of shares. It follows that the confidence in those shares were not
diminished by audit qualifications. Although Letourneau's study covered all
results of his study could surely be applied to other qualifications as most individual
investors would not be able to distinguish the difference between the different
types of qualifications. Letourneau's study showed that any perceived effect on the
share price of companies who had the qualification of their annual financial
statements announced in the Wall Street Journal, was due to other news around
the date of the Wall Street Journal qualification announcement (Letourneau,
1988:61).
A number of studies have been conducted on the effect of a qualified audit opinion
on the removal of an auditor. These studies include those of Chow and Rice (1982),
Craswell (1988), Citron and Taffler (1992), Johnson and Lys (1990) and Dye
All of these studies concluded that auditors are more likely to be removed from their
positions by companies after giving qualified audit opinions on the financial
A company who consistently removes his auditor after a qualified audit opinion may
be guilty of opinion shopping. "Opinion shopping" is defined by the American
Chapter 3 - Profit available for distribution as dividends 90
3.12.5. Conclusion
The eighth and last common law dividend rule is indisputably correct in stating that
the financial position of a company should be considered as a whole in the decision
to declare and pay dividends. If not applied, it could lead to the qualification of the
audited annual financial statements of a company. Very few small individual
investors can comprehend the full impact of such a step by the auditors of a
company. The Johannesburg Stock Exchange's training and awareness program for
small investors should address this fact as these investors would be happy with an
investment as long as they receive dividends or returns.
The discussion of the eight common law dividend rules still applicable in South Africa has
shown a number of shortcomings, particularly where accounting principles and
developments have surpassed age old common law principles. Although South African law
on dividends (or the lack thereof) has remained fairly stagnant, English law has evolved in
recent times as a result of the harmonisation of various laws in the European union.
This harmonisation process culminated in the English Companies Act of 1980. Section 39
of the English Companies Act of 1980 scrapped some of the more controversial common
law dividend rules (Cilliers et al., 1992:353). The most important stipulations in the new
South African Company law has a long way to go before it will be able to adopt
comparative rules. The process for the transformation of the Act has just begun. The trade
and industry department's standing advisory committee on the Act announced in July of
1996 that the Act and the Insolvency Act would be reworked totally (Giliomee, 1996:1).
With this purpose in mind, specific recommendations for proposed legislation will be
TABLE 3.5.
ENGLISH COMPANIES ACT OF 1980 - SECTION 39
STIPULATION: APPLIED IN
SOUTH AFRICA:
A company may not pay dividends except out of profit for that Yes.
.purpose.
Profit available for the payment of dividends does not encompass No.
unrealised profits.
Unrealised profits may not be used to write off losses or pay back No.
It may however be utilised for the payment of fully paid up bonus or Yes.
capitalization shares.
before dividends are paid to the extent that it has not been written
3.14. Summary
The calculation of profit legally available for distribution as dividends is governed by eight
common law rules devised by the Courts in predominantly England during the period 1360
to 1920.
Not all eight of the common law rules can be defended by accounting principles and
postulates. This fact has, however, had no effect in South Africa as no legislation has been
passed or prepared to correct the situation. Positive changes have, however, been made
to the Companies Acts in England and the European Union. Legislation has effectively
South African companies wishing to utilise any of the common law rules that are not
defendable by accounting principles and postulates, will be able to do so in most cases if
they cite the pertinent case law to their auditors. The auditor is in the precarious position
that it will be difficult for him to explain the problem to, particularly, an individual investor.
The application of the common law dividend rules for the calculation of profit available for
distribution as dividends are summarised in Table 3.6. Table 3.6. details the eight rules,
explains whether the rules are applied in England and South Africa and lastly indicates
Each of the eight common law dividend rules rely heavily on certain amounts that have
been recorded in the financial statements of a company. Financial statements are not
definitive, neither perfect as financial statements do not take inflation into account and
financial statements should be considered in all cases when calculating profit available for
distribution as dividends. Reported profit is after all the starting point for the calculation.
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Chapter 3 - Profit available for distribution as dividends 94
BIBLIOGRAPHY
ANON., 1 992: Sorting out the mess. Financial Mail, February 28 1 992: 40.
ANON., 1 995: Masterbond-kuratore kap skerp terug oor beweringe. Sake-Beeld, 2 Junie
1995: S3.
BELKAOUI, AR 1992: Accounting theory; third edition. London: Academic Press Limited.
BRINGHAM, EF & GAPENSKI, LC 1 988: Financial management, theory and practice; fifth
edition. Orlando: The Dryden Press.
CILLIERS, HS; BENADE, ML; HENNING, JJ; DU PLESSIS, JJ & DELPORT, PA 1992:
Korporatiewe reg; tweede uitgawe. Durban: Butterworths.
COLLIER, PA; COOKE, TE & GLYNN, JJ 1988: Financial and Treasury Management.
Oxford: Heinemann Professional Publishing Ltd.
GILIOMEE, A 1996: Company law set for radical transformation. Business Day, July 12
1996: 1.
HENDRIKSEN, ES & VAN BREDA, MF 1 992: Accounting theory; fifth edition. Homewood:
IRWIN.
KIESO, DE & WEYGANDT, JJ 1986: Intermediate accounting; fifth edition. New York:
IRWIN.
PERCY, JP 1995: The Cadbury Report and Corporate Governance in the U.K. The CPA
Journal, May 1995: 24-28.
PETER, L 1 977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973 as
amended). Pretoria: Government Printer.
THE CONCISE OXFORD DICTIONARY 1982: seventh edition. Oxford: University Press.
THE SOUTH AFRICAN BREWERIES LIMITED 1995: Centenary annual report. March 1995.
VAN DORSTEN, JL 1993: The law of dividends in South Africa. Cape Town: Obiter
Publishers.
WEDGEWOOD, T 1995: Realised profits and the cash test. Accountancy, July 1995
Volume 116 No. 1223: 113.
WEST, E 1 995a: Masterbond curators 'issued six reports'. Business Day, May 5 1 995: 2.
WEST, E 1 995b: Masterbond investors repaid R427m. Business Day, May 22 1 995: 1-2.
WOLK, HI; FRANCIS, JR & TEARNEY, MG 1992: Accounting Theory: A Conceptual and
Institutional Approach; third edition. Cincinnati: South-Western Publishing
Co.
Chapter 3 - Profit available for distribution as dividends 97
ZEFF, SA eds 1 982: The Accounting Postulates and Principles Controversy of the 1 960s.
New York: Garland Publishing, Inc.
Chapter 4 - Imperfections in financial statements 98
"One of the benefits of inflation is that kids can no longer get sick on a nickel's
4.1. Introduction
The eight common law dividend rules for the calculation of profit available for distribution
as dividends, rely heavily on several line items in the balance sheet, income statement and
cash flow statement that are included in audited annual financial statements of companies.
The objective of a set of financial statements is to provide information about the financial
position, performance and changes in the financial position of a company to a wide range
of users who make economic decisions based on information contained in a set of financial
Financial statements are, however, not perfect and may not provide satisfactory
information to all the relevant users. The quality and accuracy of information provided by
carefully. Particularly (for purposes of this thesis) those accounts, balances or values
referred to by the common law dividend rules for the calculation of profit available for
distribution as dividends.
The eight common law dividend rules refer to a number of accounts, balances or values
that are used in the application of the principles embodied in the rules. Most of these
accounts, balances or values are disclosed separately in the annual financial statements
of a company. The accounts, balances or values referred to by the common law dividend
TABLE 4.1.
ACCOUNTS, BALANCES OR VALUES REFERRED TO BY THE COMMON LAW DIVIDEND RULES
Dividends may not be paid out of share Share capital (and other equity
capital. accounts)/ Shareholder's equity.
The calculation of the maximum profit legally available for distribution as dividends should
ideally be based on audited financial statements. An unqualified audit opinion would
confirm that the solvency and liquidity of the position and results of a company as reflected
in a set of financial statements is fairly reasonable.
As discussed in paragraph 4.1. there are a number of constraints that may cause the
financial statements of a company to be inaccurate, imperfect or unrealistic.
4.3.1. introduction
balance between benefit and cost and a balance between qualitative characteristics.
The first constraint that will be discussed is that of timeliness.
4.3.2. Timeliness
Financial information may loose its relevance if there is an undue delay in financial
reporting. The longer directors delay in reporting final results for a year, the higher
the risk of basing decisions such as those for final dividends on somewhat irrelevant
or outdated results. Equally, the longer directors delay in using interim financial
results to determine the maximum amount available for distribution as interim
dividends, the greater the risk that their decision will be incorrect.
financial statements is the quest to obtain the correct balance between the
qualitative characteristics of financial statements.
Chapter 4 - Imperfections in financial statements 101
The qualitative characteristics of financial statements are the attributes that make
information useful to users (SAICA, 1990:par.24). Statement of Financial
Accounting Concepts No. 2 Qualitative Characteristics of Accounting Information
states that qualitative characteristics are those characteristics that distinguish the
more useful accounting information from less useful accounting information (Kirk
& Siegel, 1 996:55):
Each of the four groups should be considered by management in setting and using
financial statements for decisionmaking pUrposes. The first of the groups of
qualitative characteristics to be considered is the understandability of financial
statements.
4.3.4.1. Understandability
have the responsibility to create financial statements. Section 286 of the Act
requires of the directors of a company to make out annual financial
statements and to lay these financial statements before the annual general
Chapter 4 - Imperfections in financial statements 1 02
meeting of such a company (South Africa, 1 973). Directors will have access
to additional information to that which is provided in the financial
statements. The directors' understanding of the information in financial
statements, which is crucial to accurate economic decisionmaking may be
supplemented by such additional information. It will be up to the users of
financial statements to decide whether they can rely on the ability of
directors to use all the information available to them in the decisionmaking
processes in a company.
4.3.4.2. R6avance
The decision process used in the calculation and payment of dividends may
be based on a set of financial statements. All the relevant information
required for the calculation of profit available for distribution as dividends is
incorporated in a standard set of annual financial statements as discussed
in paragraph 4.2.
Reabilitv
faithfully. Directors may not always have full control over this attribute
substance of transactions or other events and not merely the legal form of
that legal ownership has passed from the company to a client while this is
economically and substantially not the case. These events could occur in
order to free revenue and profit on current assets or fixed assets that may
information and to make their own conclusions from it about the future value
of a company when realised while provision should be made for all known
liabilities, expenses and losses whether the amount is known with certainty
prudent reporting based on healthy scepticism will build confidence and will
best serve all the divergent interests of users of financial statements (Kirk
& Siegel, 1996:55). Based on the discussion of the common law dividend
in paragraph 3.8. and 3.10.) could lead to the misuse of the common law
4.3.4.4. CompavabiDity
fixed assets from time to time when a company does not earn sufficient
trading profits.
4.3.5. Conclusion
The constraints of timeliness, a balance between benefit and cost and a balance
such information (SAICA, 1990:par.46). If these standards and principles are not
The lack of the application of these standards and characteristics are not the only
imperfections in financial statements.
4.4.1. Ontvoduction
point for the calculation of profit available for distribution as dividends as discussed
in paragraph 2.4.4. The directors of a company wishing to perform such a
calculation will be concerned with the level of accounting profit available for this
purpose. There are a number of selective accounting techniques that may be utilised
Chapter 4 - Imperfections in financial statements 106
Some of the techniques that may be used to create the impression of a high level
of accounting profit includes:
changes to depreciation policies (discussed in paragraph 4.4.2.);
capitalization of interest (discussed in paragraph 4.4.3.);
writing off of goodwill (discussed in paragraph 4.4.4.) and
brand accounting (discussed in paragraph 4.4.5.) (Ellis & Williams,
1993:149).
The first of the techniques to enhance accounting profit that will be discussed is a
change to the depreciation policies of a company.
It was established in paragraph 3.7.4. that depreciation is the allocation of the cost
of fixed assets over the useful lives of the assets. An extension of the period over
which depreciation is written off may dramatically alter the level of accounting
profits declared in the income statement.
A numerical example follows in Table 4.2. to illustrate the effect of a change in the
depreciation policy on the profit of a company (Ellis & Williams, 1 993:1 50).
The second technique that may be applied to enhance the profit of a company is
the capitalization of interest.
Chapter 4 - Imperfections in financial statements 107
TABLE 4.2.
EXAMPLE - CHANGE TO DEPRECIATION POLICY
Company A has a turnover of R1 50m and cost of sales amounted to R80m, including . R25m to
cover depreciation. Assume the company's output is generated from new machinery which cost
R100m. Currently, Company A writes the cost of the asset off in equal instalments over four
years. Assume now that the company changes its accounting policies and writes the machinery
off in equal instalments over ten years, at a cost of R1Om per annum.
borrowing costs, which includes interest, that are directly attributed to the
acquisition, construction or production of an asset that necessarily takes a
substantial period of time to get ready for its intended use should be capitalized as
Chapter 4 - Imperfections in financial statements 1 08
part of the cost of that asset. The requirements for capitalization in terms of AC
1 14 Borrowing costs should, however, be met at all times.
The third technique for enhancing profit is the selection of a particular basis for the
writing off of goodwill that would suit either the balance sheet or the income
price of an asset over the net asset value acquired. There are two bases that may
A company electing to capitalize goodwill, will write the goodwill asset off over a
number of years. The goodwill will be spread over a period with the effect that
reported profits are lowered. This particular practice is followed in the United States
of America (Ellis & Williams, 1 993:1 53). Goodwill is written off over forty years in
the United States of America (Cooke, 1 993:465). The maximum profit available for
company. The reserves of the company will consequently be reduced whilst the
the balance sheet will, however, be affected. The effect of the second technique
on the calculation of the maximum profit available for distribution is that profit for
the current year which is the starting point for the calculation will be maintained.
The overall solvency of the company will, however, be more difficult to maintain if
the goodwill costs which are written off against reserves are high.
The fourth techniques for the enhancement of profit is placing a value on brands
acquired and classifying brands as intangible assets rather than categorising brands
as goodwill that should be written off over a period. Depreciation is generally not
Chapter 4 - Imperfections in financial statements 109
provided for on brands. One of the British Companies who have elected to apply
such a policy is United Biscuits plc. The applicable note in the annual financial
"A fair value is attributed to brands at the date of acquisition by the group
review their value each year and the cost will be written down if, in their
opinion, there has been a permanent diminution in value" (Ellis & Williams,
1993:153).
The saving resulting from techniques such as brand accounting may have a positive
The directors of companies and shareholders may pull in two directions with regard to
profit and cash. Directors tend to want to maximise profit and shareholders tend to want
Accounting profit should not be the sole consideration in evaluating the results of a
company. The company's cash flow position should also be considered. Ellis & Williams
devised ten questions to enable analysts to assess a company's cash flow statement
(1993:183). These questions are expressed in Table 4.3.
TABLE 4.3.
TEN QUESTIONS DESIGNED TO ENABLE ANALYSTS TO ASSESS A COMPANY'S CASH
FLOW STATEMENT
Is the company managing to increase the net cash inflow from its operating activities?
'How important has the disposal of fixed assets and/or business been in terms of
generating funds?
The quality of profit in terms of cash generated from operations should clearly be
be known to management, it could be difficult for them to quantify the effect of the factors
on future levels of profitability when setting dividend policies. Examples of some of the
factors that are difficult to quantify are the qualifications of the management team
members and the quality of the company's human resources compliment (Correia, Flynn,
Financial statements are a simplified and summarised record of the highly complex and
simplification and summarisation results in a loss of some clarity and detail that is often
position with regard to simplification and summarisation as they are able to identify and
obtain any additional information they might require in making decisions. ThiS also applies
to decisions on dividends.
4.8. Inflation
Inflation has a negative effect on the general purchasing power of money. In periods of
inflation an economy is characterised by two features. The first is a rise in the general level
of prices and the second a change in the structure of prices or shifts in specific prices. The
The South African economy has been under pressure for more than a decade due to the
effect of, among others, a high rate of inflation. The dawning of the new South Africa has
had a positive effect on local inflation. Inflation is at an all time low of 6,5% in February
.1996 from 6,9% in January 1996. Economists expect inflation to cool down even further
to 5,5% in April 1996 before picking up to bring inflation for the year to an expected 7%
(Soggot, 1996:1). In May 1996 producer price inflation rose to 5,8% from 5,3% in April
1996 (Mnyanda, 1996:1).
Accounting profit provides an indication of the earning power and future cash flows of a
company. The relationship between factors affecting a company's ability to pay dividends
are reflected in Table 4.4. (Mathews & Perera, 1991:169).
Chapter 4 - Imperfections in financial statements 112
TABLE 4.4.
Accounting
lo- income
Calculation of
Conventional financial accounting, on which Table 4.4. is based, does not make any
provision for the changes in the value of money or the purchasing power of money as a
result of inflation.
Inflation or the purchase power of money has a significant effect on the dividend policy of
a company. In periods of high inflation, such as those experienced in South Africa over the
greater part of the last decade and a halve, directors must have regard for the fact that
even larger retained earnings are required to maintain the current operating capacity of a
company. While companies may appear to do their utmost in the short term to maintain
dividend payments in money terms, in the longer term it is questionable whether dividends
can actually be maintained (Collier, Cooke & Glynn, 1 988:1 50).
consequently be more realistic, although the application of the rule will still be conceptually
incorrect. Inflation and its impact on dividends is an unclear area of financial management
today in South Africa. Although the subject of inflation falls out of the ambit of this study,
the effect thereof on dividends can be researched independently.
Companies are no longer able to smooth earnings per share subjectively by taking unusual
items below the normal profit line or by exercising judgement on what constitutes
extraordinary items. These smoothing techniques were possible prior to the release of AC
103 Net profit or loss for the period, fundamental errors and changes in accounting policies
(SAICA, 1 995b). The introduction of this statement has also barred companies from using
abnormal items, as the net profit or loss for a period comprise only profit or loss from
ordinary activities or extraordinary items (SAICA, 1 995b:par.09).
4.10. Summary
Financial accounting and reporting of financial information in the balance sheet and income
statement of a company is the particular branch of accounting that provides a continual
history, quantified in money terms, of the economic resources and obligations of a
company and of the economic activities that change these resources and obligations (Kieso
& Weygandt, 1986:1).
The unsophisticated reader of a company's financial statements can easily fail to realise
that profit disclosed in the financial statements is anything but definitive.
practices such as enhancing profit at the expense of the balance sheet may also distort
financial statements. Limitations on financial statements that are imposed involuntarily by
monetary expression terms, the simplification and summarisation of financial statements
as well as the effect of inflation will have an important effect on the decisions taken by
Chapter 4 - Imperfections in financial statements 1 14
directors, analysts and investors. As the calculation of profit available for distribution as
dividends relies heavily on the information in financial statements, the dividend decision
Just as the decisions of directors will be influenced by the information in and imperfections
Once the financial statements of a company has been adjudged to be relevant, reliable and
a fair presentation, the effect of different dividend policies on financial statements have to
be considered. Different dividend policies will effect reserves, profit and earnings per share
Chapter 5 of this thesis will review a number of dividend policies available for
implementation by the directors of a company.
Chapter 4 - Imperfections in financial statements 115
BIBLIOGRAPHY
COLLIER, PA; COOKE, TE & GLYNN, JJ 1988: Financial and Treasury Management.
Oxford: Heinemann Professional Publishing Ltd.
COOKE, TE 1 993: The Impact of Accounting Principles on Profits: The US versus Japan.
Accounting and Business Research, Volume 23 Number 92 Autumn 1993: 460-
476.
ELLIS, J & WILLIAMS, D 1993: Corporate Strategy and Financial Analysis. London: Pitman
Publishing.
KIESO, DE & WEYGANDT, JJ 1986: Intermediate accounting; fifth edition. New York:
IRWIN.
KIRK, DJ & SIEGEL, A 1996:How Directors and Auditors Can Improve Corporate
Governance. Journal of Accountancy, January 1 996: 53-58.
MATHEWS, MR & PERERA, MHB 1991: Accounting theory and development. London:
Chapman and Hall.
MNYANDA, L 1 996: Producer inflation up to 5,8% in May. Business Day, July 12 1 996: 1.
PETER, L 1 977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SOGGOT, M 1996: Inflation cools as food prices fall. Business Day, March 29 1996: 1.
Chapter 4 - Imperfections in financial statements 116
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973 as
amended). Pretoria: Government Printer.
"The poor you always have with you." - Jesus (Peter, 1977:394).
" In every well-governed state wealth is a sacred thing; in democracies it is the only
sacred thing." - Anatole France (Peter, 1977:491).
5.1. Intvoduction
The directors of a company make use of, among others, the information in financial
statements, imperfect as financial -statements are, as a basis for their decisions. The
decisions taken by directors similarly often affect how and at what value information is
disclosed in financial statements. One of the decisions taken by directors that would affect
financial statements, is the dividend policy adopted by a company. Different dividend
policies will affect reserves, profit and dividends per share in different ways.
The selection of an appropriate dividend policy is a study in its own right. This thesis will
only provide a brief look at the different dividend policy'options available to directors and
its effect on the South African economy at large.
Directors who are given the task of setting the dividend policy of a company have a
number of options available for consideration. Literature on financial management classifies
dividend policies in a number of ways. The options listed below are the most frequently
listed options available for consideration. These dividend policy options are:
a residual dividend policy (discussed in paragraph 5.3.) (Bringham & Gapenski,
1988:466-469);
constant or steadily increasing dividends (discussed in paragraph 5.4.) (Bringham
& Gapenski, 1988:469-471);
constant payout ratio (discussed in paragraph 5.5.) (Bringham & Gapenski,
1988:471);
stable dividend growth rate (discussed in paragraph 5.6.) (Kriek, 1995:1-2);
Chapter 5 - Dividend policies 118
low regular dividends plus extra (discussed in paragraph 5.7.) (Bringham &
Gapenski, 1988:471-472) and
dividend irrelevance (discussed in paragraph 5.8.) (Kriek, 1995:1-2).
Bringham and Gapenski made it clear that one dividend policy is not better than another.
Empirical tests do not answer the question of which dividend policy is correct (1988:466).
The characteristics, advantages and disadvantages of the listed dividend options will be
discussed below.
A residual dividend policy results in dividend variability from one year to another.
In one year when investment opportunities are good, a company would declare zero
dividends, whereas in the next year the same company with poor investment
opportunities, might declare large dividends. Similarly, fluctuating profit levels would
lead to variable dividends even if investment opportunities were stable over time
(Bringham & Gapenski, 1988:469).
The total amount of dividends paid for the year as reflected on the face of the
income statement of a company electing to adopt this policy will vary from
dividends paid in previous or subsequent years. Dividends per share will
Chapter 5 - Dividend policies 119
consequently also fluctuate from year to year given that the number of issued
TABLE 5.1.
EXAMPLE - RESIDUAL DIVIDEND POLICY
The advantage of the residual dividend policy centres around the fact that the
whether a shareholder can eventually earn more from internal re-investment in the
et al., 1987:544).
The disadvantage of the residual dividend policy is that the value of dividends
fluctuate on a yearly basis.
dividend stabilization fund for application in leaner years with the objective of
stabilization fund will source additional dividend payments in those years when
internal re-investment is higher than normal or profit lower than levels generally
returned.
of dividends is paid year after year irrespective of profit for that particular year
(Reynders et al., 1987:541-543). The amount of the dividends will only change to
a higher level once a new, relatively stable level of profit is maintained for a period
which would create a steady increase in dividends. There is, however, a time delay
before the next level of dividends is reached.
A reduction in total dividends paid is to be avoided at all costs. The greater the
stability of the profit of the company, the greater the possibility that a stable
dividend policy will be adopted.
The total amount of dividends paid as reflected on the face of the income statement
Chapter 5 - Dividend policies 121
should remain constant from year to year until such time as an increase occurs.
After the increase the stable dividend pattern should continue. If the number of
shares of the company in issue remains constant, dividends per share will also
remain constant from year to year until such time as an increase occurs.
The first advantage of the constant or steadily increasing dividend policy is that the
confidence of investors and creditors are maintained at a specific level regardless
of the profit of the company. The impression is created that the company can
maintain its profit levels regardless of possible current decreases or risk factors. The
policy will have a positive effect on the market price of the shares (Reynders et al.,
1987:542-543).
A second advantage is that the implementation of the policy has a positive effect
on the liquidity, solvency and cash position of the company. Surplus cash is not
distributed and can be re-invested in the company.
A third advantage is that the policy creates a lower critical rentability that decreases
the risk profile of the company. This advantage stems from the complicated "capital
asset pricing model" which falls out of the ambit of this study (Reynders et al.,
1987:-342365).The capital asset pricing model analyses the relationship between
risk and rates of returns.
The fourth advantage of the policy is that investors can be relatively assured of a
stable income. A stable income assists in the financial planning of those
shareholders who have a particular need for stable income levels.
A fifth advantage is that the policy assists the sustained growth of the company as
a constant dividend policy is perceived to be relatively conservative.
time. The shareholders will receive the additional payout on the basis that it will not
be repeated (Reynders et al., 1 987:543).
The third dividend policy that will be discussed is that of a constant payout ratio.
the face of the income statement as well as dividends per share will fluctuate from
year to year. The ratio between profit and dividends will remain constant.
The advantage (Reynders, et al., 1 987:543) of the policy is that an investor will be
A company adopting a stable dividend growth rate policy, elects to set a particular
dividend growth rate for dividends to be applied on a yearly basis (Reynders et al.,
1987:543). Obviously earnings must grow at a reasonably steady rate for this
Chapter 5 - Dividend policies 123
The total amount of dividends on the face of the income statement as well as
dividends per share will increase from year. to year given a constant number of
shares in issue.
The main advantage of this policy is that investors are compensated for the
The disadvantages include the fact that the increase in the growth rate of the
dividends may not be matched by a similar growth rate in the distributable profit.
This would erode the quality and quantity of profit available for re-investment into
the company.
South African Breweries Limited. The policies and objectives adopted by this
company regarding dividends are set out in Table 5.2. and Table 5.3. The relevant
financial information has been extracted from the company's centenary report for
1995 (The South African Breweries Limited, 1995:10,60).
TABLE 5.2.
THE SOUTH AFRICAN BREWERIES LIMITED
DIVIDEND POLICY AND OBJECTIVES
Retain sufficient earnings to Continue distributing regular and Dividends increased by 29% in
sustain planned net asset improving dividends, covered the year ended 31 March 1995
growth without breaching the approximately 2,3 times by and have increased by a
TABLE 5.3.
THE SOUTH AFRICAN BREWERIES LIMITED
DIVIDENDS v EARNINGS IN CENTS PER SHARE
The fifth dividend policy to be discussed in that of low regular dividends plus extra.
A low, but regular dividend payout policy plus extra is characterised by a low
regular dividend payout that allows for additional dividend payments to shareholders
in years when profit levels are very high. Additional dividend payments may be
made in any form including cash dividends. Companies adopting the policy in the
United States of America include General Motors and Eastman Kodac Company
(Bringham & Gapenski, 1988:471-472).
The total dividend payment on the face of the income statement as well as
dividends per share may vary from year to year. The variation will, however, be
relatively small except for those years when additional dividends are paid.
Thereafter total dividends and dividends per share should drop to lower levels.
Chapter 5 - Dividend policies 1 25
minimum stable dividend return for investors (Bringham & Gapenski, 1988:471).
the theory of Merton Miller and Franco Modigliani contends that the dividend policy
shares nor its cost of capital (Correia et al., 1989:598). Miller and Modigliani's
reasoning was based on the theory that the value of a company is determined by
its basic earnings power and risk profile. The company's value would depend on its
asset investment policy rather than the manner in which profit are split between
dividends and retained earnings.
Miller and Modigliani believed that a company that has acceptable investment
opportunities and a stated debt policy, will have to raise finance to pay dividends
by issuing new shares. The shareholders will subsequently be in no different
Position, whether dividends are paid or not. If dividends had been paid, the
shareholders would have received cash. To raise that finance, the company would
have had to issue shares of a value equal to the total dividend amount. This would
lead to more shares in issue for the same assets, which in turn would dilute the
dividends received by shareholders (Correia et al., 1989:598).
Reality is, however, that all three these assumptions are invalid under realistic
market conditions. In spite of the Miller and Modigliani theory, shareholders might
also prefer to be paid dividends by the companies in which they have invested
(Hines, 1996:666).
G. Bennett Stewart III, co-founder of Stern Stewart & Co with the equally
well-respected Joel Stern, makes the statement that dividends do not matter at all
in his book "The Quest for Value" (1991:43). He contends that the payment of
"Companies are valued for what they do, not for what they do not do. By
paying dividends, management has less money available to fund growth.
The value of profitable investment opportunities foregone is subtracted from
the share price."
s hares, however, experienced the same overall rate of return over time.
Stewart's opinion the best option is, however, to buy back shares held by
accomplished with, among other stipulations, the sanction of the Courts in terms
Joel Stern echos the views of his partner Stewart by stating that dividend payments
really mean that a company has an insufficient number of projects on which the
expected rate of return at least equals the cost of capital, which is the rate of return
companies not to pay dividends as most of them argue that dividend payments are
a primary signal to investors that their companies are doing well financially. The
The latest South African company to apply the policy of paying no dividends to
their shareholders is Engen Africa a subsidiary of Engen that was listed at the end
of February 1996. Energy Africa's managing director John Bentley said that the
company would not be paying dividends on its issued shares in the foreseeable
future as future earnings will be reinvested into the business to service the
company's aggressive growth strategy (Sharpe, 1 996:9).
Chapter 5 - Dividend policies 1 28
The King Report on Corporate Governance identified a number of stakeholder groups such
as bankers, customers, the state and employees that may not be overlooked in the
decision-making processes of companies. These stakeholders affect a company in a
number of ways, for example in requiring affirmative action programmes and requiring
greater accountability and reporting in relation to the company's non-financial affairs
(KPMG, 1995:5).
TABLE 5.4.
THE SOUTH AFRICAN BREWERIES LIMITED
STAKEHOLDER ACHIEVEMENT APPRAISAL
Essential to SAB's success is its ability to create and add value in the markets and communities
it serves. During the year under review, value added in cash terms exceeded the R10 billion
mark, bringing the compound growth rate achieved over the last seven years to 20,5% per
annum, and representing a very substantial ongoing contribution to the country's growth and
development. In order to sustain such a high rate of value creation, a fair, equitable and balanced
The Foschini group has emphasised its contribution to the nation in the 1995 chairman's
statement that is reflected in Table 5.5. (Foschini Annual Reports, 1995:4).
Chapter 5 - Dividend policies 129
TABLE 5.5.
THE FOSCHINI GROUP
CONTRIBUTION TO THE NATION
Foschini's income generating capacity has enabled it to play a significant role in contributing
not only to shareholder wealth, but importantly to the welfare of the nation. Over the past
decade alone it has collected indirect taxes on behalf of the fiscus of some R1,1b and has
paid direct taxes in excess of R700m. Additionally over the period, R1,4b has been paid in
salaries and wages to our work force (presently 6,500), and R5,4b for goods and services,
Both The South African Breweries and the Foschini Group have been skillful! in disclosing
their respective earnings power and taxation contributions in such a way that the benefit
to South African society is highlighted.
In South Africa, the policies adopted by companies affect not only the shareholders and
stakeholders but also society at large as it is imperative that the business community takes
the objectives of the South African Reconstruction and Development Program into account
in decisionmaking as a part of socially responsible management.
The objective of the Reconstruction and Development Program was put into perspective
by President Nelson Mandela in his Inaugural Address to a Joint Sitting of Parliament on
May 24 1994. President Mandela said the following:
"My Government's commitment to create a people-centred society of liberty binds
us to the pursuit of the goals of freedom from want, freedom from hunger, freedom
from deprivation, freedom from ignorance, freedom from suppression and freedom
from fear. These freedoms are fundamental to the guarantee of human dignity. They
will, therefore, constitute part of the centrepiece of what this Government will seek
to achieve, the focal point on which out attention will be continuously focused. The
thing we have said constitutes the true meaning, the justification and the purpose
of the Reconstruction and Development Program, without which it would lose all
The choice of a particular dividend policy also has an indirect effect on analysts, competitor
companies and employees. On a broader level, the stakeholder community identified by the
King Report on Corporate Governance as well as the nation's wealth needs will be affected
The success of the RDP will be determined in part by the way in which the public and
private sectors work together for the good of South Africa. The RDP, after all, provides a
consistent, coherent framework within which several key economic initiatives can be
applied simultaneously and in a mutually reinforcing manner.
A fine line exists between attaining the goals of the company, providing a return on
investment and appeasing the majority of the population of a country.
BIBLIOGRAPHY
ANON.,. 1 994: RDP White paper discussion document. Cape Town: CTP Book Printers.
ANON., 1 995: Growth rather than welfare. Financial Mail, December 8 1 995: 17.
BRINGHAM,- EF & GAPENSKI, LC 1 988: Financial management, theory and practice; fifth
edition. Orlando: The Dryden Press.
FOSCHINI ANNUAL REPORTS 1995: 1995 Foschini Limited, Lewis Foschini Investment
Company Limited.
HINES, JR 1 996:Dividends and Profits: Some Unsubtle Foreign Influences. The Journal of
Finance, Vol 51 June 1996: 661-689.
KRIEK, JH 1995: Dividendbeleide, kapitaalstruktuur, handhaaf bare groei, module 9 II, KE-
Kursus 1995, Finansiele Bestuur. Johannesburg: Randse Afrikaanse Universiteit.
PETER, L 1 977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SHARPE, S 1996: No payouts on shares, says Energy Africa MD. Business Day, February
1 1996: 9.
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973) as
amended). Pretoria: Government Printer.
Chapter 5 - Dividend policies 134
STEWART, GB III 1991: The Quest for Value. New York: HarperCollins.
THE SOUTH AFRICAN BREWERIES LIMITED 1 995: Centenary annual report. March 1995.
Chapter 6 - Rules for the payment of, and different forms of dividends 1 35
"The greater the number of laws and enactments, the more thieves and robbers
6.1. introduction
The directors of a company should base the calculation of profit available for distribution
as dividends on several common law dividend rules. An appropriate dividend policy should
then be applied in determining the final amount of dividends to be declared and paid. The
dividend decision is then, however, still not finalised as the directors should take
cognisance of a number of rules that should be applied when declaring and paying
dividends. The form of the dividend payments should thereafter be selected based on the
overall financial strategy of the company.
6.2.1. introduction
Apart from the common law dividend rules applied in the calculation of profit
available for distribution as dividends, the payment of dividends is governed by a
number of other rules and related issues that should be considered in the decision
to declare and pay dividends. The first of the rules or issues relating to the payment
of dividends are contained in the Act.
The Act provides for a number of rules to be applied in the calculation, declaration
and payment of dividends (South Africa, 1973). These rules are, however, hot
applicable to all companies as the rules are not contained in the main body of the
Act. The rules only apply to companies who have adopted Schedule 1 of the Act
Chapter 6 - Rules for the payment of, and different forms of dividends 1 36
private companies with share capital. The rules can be summarised as follows:
dividends declared by the annual general meeting may not exceed the
the directors may, from time to time, pay an interim dividend to the
members of a company;
the directors may, before recommending dividends, set aside out of profits
of the company such sums as they think fit as a reserve which may be used
the directors may carry reserve funds forward which they may think prudent
not to divide;
entitlement;
time to time determine, and shall, if paid otherwise than by coupon, either
shall be a good discharge to the company in respect thereof. Any one of two
or more joint holders may give effectual receipts for any dividends or other
moneys payable in respect of the shares held by them as joint holders and
the company shall not be responsible for the loss in transmission of any
cheque, warrant, coupon or other document sent through the post to the
The main body of the Act that is applicable to all companies does not refer directly
to any other rule or stipulation that should be applied in the calculation, declaration
and payment of dividends. The sections of the Act discussed below may have an
indirect effect on the payment of dividends.
The directors may not be protected from this obligation. Section 247 of the
Act expounds that any indemnity given to a director in respect of any
negligence, default, breach of duty or breach of trust of which he may be
guilty shall be void. Section 248, however, provides relief in cases where
directors have acted honestly and reasonably (South Africa, 1 973).
company."
The scope for the application of section 38 is very wide as it is not restricted
the Courts is also not necessarily the only test to be applied as was the
warning sounded in the case of Lipscitz v UDC Bank 1979 1 SA 789 (A)
38 can still pay dividends and publicize that the purpose of the payment is
Schedule 1 (or similar stipulations) of the Act will have a maximum amount
half of the amount of the issued share capital plus the amount of the share
premium account or of the stated capital account (South Africa, 1 973). The
of factors.
The first of these factors is the current level of external borrowings of the company.
borrowing powers at their disposal. When external funding exceed the borrowing
powers of the directors or will exceed those powers after the external funding have
been obtained, the decision to obtain additional external funding is out of the hands
Of the directors. Shareholders will have to give their permission for borrowings
The second factor to consider is the timing of future cash streams, if any, which
directors expect to realise from the business of the company. If it appears that the
company will not earn sufficient cash streams in the foreseeable future in order to
repay additional borrowings obtained to pay dividends, the wisdom of the decision
to pay dividends from external funding should be considered carefully in the light
of liquidity concerns.
Thirdly, the applicability of the going concern concept in the preparation of the
account by the directors. The going concern concept implies that the company will
continue in operational existence for the foreseeable future. This means that the
external borrowings. The liability relating to the additional external funds will be
reflected on the face of the balance sheet and the interest charge in the notes to
Lastly, the decision to pay dividends from borrowed funds has an impact on the
current taxation liability of a company. Section 11 (a) of the Income Tax Act allows
for deductions from taxable income of losses and expenses in the production of
income that is not of a capital nature (South Africa, 1962). Interest paid to the
contributors of external funds is, therefore, normally deductible from taxable income
in the calculation of the current income tax liability of a company. Care should,
funding used in the payment of dividends. Section 10 (k) (i) of the Income Tax Act
Chapter 6 - Rules for the payment of, and different forms of dividends 140
states clearly that dividends are exempt from taxation (South Africa, 1 962). Since
dividends attract no taxation and are regarded as of a capital nature, interest paid
on borrowed funds used in the payment of dividends, will not be deductible from
taxable income. The effect on the future cash flow of a company resulting from
interest charges that are not deductible from taxable income should be considered
by the directors of a company.
Directors should also consider other restrictive factors when obtaining external
funding.
The directors of a company should take note of the stipulations of, among others,
loan agreements applicable to a company before obtaining external funding. One of
the conditions of a loan agreement may be a restriction on the payment of dividends
(Correia, Flynn, Uliana & Wormald, 1989:601).The consequences of breaking these
restrictive covenants may be grave for the business of a company.
If directors are still resolute in their decision to pay dividends, they should consider
the disclosure consequences of such a step.
Schedule 4 of the Act requires that the following information is disclosed with
regard to dividends:
"42 (c) the aggregate amount of the dividends paid and proposed,
and if such dividends are provided partly or wholly from
capital profits, a statement to that effect" and
"42 (I) earnings per share and dividends per share in respect of listed
companies for each class of equity share" (South Africa,
1973).
Earnings and dividends per share. Dividends per share is defined as the dividends
declared or proposed for a period by a company divided by the respective number
of shares in issue at the date of each dividend declaration (SAICA, 1 992:par.04).
Dividends may fluctuate from year to year as a result of the application of a specific
dividend policy or a change to the dividend policy adopted by a company. A range
of dividend policies was listed in paragraph 5.2.
Paragraph .36 of AC 104 Earnings and dividends per share (SAICA, 1 992) states
that where a company has had a change in the number of shares in issue without
a corresponding refund of capital, the corresponding dividends per share disclosed
in respect of all earlier periods should be proportionately adjusted.
6.2.6. Conclusion
The directors of a company should consider a wide range of restrictive rules and
issues in the decision to pay dividends to shareholders. Once all the factors have
been considered, the directors should come to a final decision on the cash
equivalent amount of dividends to be declared and paid. The form that the dividends
should take on must then be determined.
Chapter 6 - Rules for the payment of, and different forms of dividends 142
One of the elements of the definition of dividends as stated in paragraph 2.2.6. is that
dividends may be regarded as a payment, allocation or division of some form. Some of the
suggested forms of dividend payments are:
cash dividends (discussed in paragraph 6.4.);
bonus dividends (discussed in paragraph 6.5.);
dividend in specie or kind or property (discussed in paragraph 6.6.);
share splits (discussed in paragraph 6.7.);
capitalization awards (discussed in paragraph 6.8.) and
scrip dividends (discussed in paragraph 6.9.).
The final choice on the form that the dividend payments should take will be reliant on the
goals that the company would want to achieve with the payment and the resources at the
company's disposal.
Cash dividends is a form of dividend payment made in cash terms which is normally paid
to shareholders by way of a cheque. The payment of dividends in the form of cash is the
most common form of dividend payment used by companies (Reynders, Lambrechts &
Scheurkogel, 1987:558).
In general most companies pay dividends twice a year through an interim and final dividend
payment. Dividends are then distributed to shareholders registered at the last date of
registration (Kieso & Weygandt, 1986:662).
The decision to pay interim dividends lies in the hands of the directors of a company and
is effected by means of a directors' resolution. The payment of interim dividends is not
declared before payment. Interim dividends are merely paid in terms of the directors'
resolution and articles of association (Van Dorsten 1 993:36). The directors' resolution to
pay interim dividends may be rescinded at any time before the dividends are actually paid.
Chapter 6 - Rules for the payment of, and different forms of dividends 143
The payment of interim dividends and the declaration of final dividends create a current
liability on the balance sheet of a company (Kieso & Weygandt, 1 986:662). The following
journal entry should be recorded in the books and records of a company at the time of the
At the time of the actual payment of the dividends the liability will be reversed with the
In general, most South African companies make use of cash payments for interim dividends
regardless of the form of the final dividends that are paid. Examples of South African
companies who have recently elected to pay dividends in the form of cash payments
include Kolosus Holdings Ltd, Irwin & Johnson Ltd, New Africa Investments Ltd, Pick 'n
Pay Holdings Ltd, Pretoria Portland Cement Co. Ltd, Standard Bank Investment Corp. Ltd
Bonus dividends is a form of dividend payment which is sourced from the accumulated
earnings of a company brought forward from prior financial years. Bonus dividends are,
capitalization awards as long as the bonus dividends are sourced from prior year
Dividends in specie or kind or property are dividends payable in the form of assets. This
company to its shareholders. The only prohibition against the payment of dividends in the
form of assets may lie in the articles of association of a company that may prohibit the
distribution of the assets of a company in the form of dividends (Van Dorsten, 1993:31).
The acceptability of the payment of dividends in the form of assets was confirmed by the
Courts. Lindley LJ put the point forward in the . case of Verner v General & Commercial
meaning of the Companies Act, there is no law which prohibits the division of such
Dividends in specie may take on any form for example stock, real estate or investments.
The obvious difficulty with dividends in specie is that the assets so transferred may not be
investments may be relatively easy to divide among shareholders. For example, DuPont's
23 percent interest in General Motors was held by the United States Supreme Court to be
in violation of antitrust laws. In 1957 DuPont was ordered to divest itself of the General
Motors shares within ten years. The shares represented 63 million shares of General
Motors' 281 million shares. DuPont could not sell the shares in one block of 63 million, nor
could it sell six million shares annually for the next ten years without severally depressing
the value of the General Motors shares. At the time the typical yearly trading volume in
General. Motors shares did not exceed six million shares. DuPont solved the problem by
declaring a property dividend and distributing the General Motors shares as a dividend to
Another difficulty with dividends in specie or kind or property is the value placed on the
assets so transferred. For the sake of the comparability of dividend payments in future
years, the value of the transferred assets should be the fair value realisable at the time of
declaration if the assets are sold (Kieso & Weygandt, 1986:664). At the time of the
Chapter 6 - Rules for the payment of, and different forms of dividends 145
TABLE 6.1.
EXAMPLE - DIVIDENDS IN SPECIE
Trendier Ltd transferred some of its investments in marketable securities costing R1 250 000
January 30, 1986, to shareholders registered at January 15, 1986. At the date of declaration
the securities have a market value of R2 000 000. The entries to records the transactions in
1953 as:
Chapter 6 - Rules for the payment of, and different forms of dividends 146
The par value of shares are detailed in the memorandum of a company. As share
splits affect the par value of shares in issue, the award should conform to a number
of requirements in different sections of the Act.
In terms of section 75 of the Act, a company may alter its share capital and shares
in a number of ways. Section 75 (1) (e) states that a company may subdivide its
shares, or any of them, into shares of smaller amounts than is fixed in the
memorandum. The subdivision, in this case, will constitute a share split. The
subdivision has to be allowed by the articles of association of a company and
authorised by way of a special resolution in terms of section 199 of the Act (South
Africa, 1973).
After a share split has been effected, the shareholders of a company will own
shares of a different par value to those detailed on share certificates issued to them
at the original acquisition of the shares. In terms of section 96 of the Act, new
share certificates have to be issued to members within two months after the
allotment of shares (South Africa, 1 973). The issue of new share certificates will
result in additional costs to a company. The costs involved are not the only
negative factors that need to be considered before a share split is effected.
Chapter 6 - Rules for the payment of, and different forms of dividends 147
Apart from the cost implication of share splits, the new price level of the shares of
a company may be lower than the price level before the issue, as a greater number
Of shares are in issue. The new market price of the shares could place the company
at the lower end of the market in the peer group in which the company finds itself
(McGough, 1 993:59). There are, however, not only disadvantages to the issuance,
but also advantages.
Share splits will increase the number of shares of a company that are in issue and
available in the market. The general marketability and liquidity of shares will
increase as the market price of the shares should decrease. The company may be
in a position to attract smaller investors who may now be in a position to afford to
Purchase shares in the company. The holders of odd-lot shares may also be
converted to round-lot holders (McGough, 1993:59).
The accounting for share splits recognise that there is no intention to distribute
accumulated profits. Accordingly, no accounting entries are required if the number
of shares increase in proportion to the decrease in the par value of the shares.
Just as capitalization awards and scrip dividends have become very popular in
South Africa, so have share splits become widely used as a means of providing
shareholders with a form of return on their investments. South African companies
who have utilised share splits during 1995 and 1996 include Anglovaal Ltd, Genbel
(SA) Ltd, Murray & Roberts Holdings Ltd, Oceana Fishing Group Ltd and Richemont
Securities AG (The Investors Guide, 1996:81,182,278,293,349).
Chapter 6 - Rules for the payment of, and different forms of dividends 148
Capitalization awards are often referred to as bonus shares which is not to be confused
with bonus dividends which were discussed in paragraph 6.5. Capitalization or bonus
shares can be defined as free issues of new, fully paid-up shares to existing shareholders
proportionately to their existing shareholding (Voogt, 1 995:39). Shareholders are not given
any alternatives in this regard and will only receive additional shares in the company in
which they have invested.
Just as scrip dividends became fashionable with the introduction of STC in 1993, so did
capitalization awards with the enactment of the Income Tax Act 85 of 1974 (Voogt,
1 995:38). Prior to this enactment, a capitalization award by a company was akivays treated
as a dividend, unless it was paid up by means of the share premium account of a company
and, therefore, at the time attracted tax in the hands of the shareholders (Divaris,
1975a:181). With effect from 1 January 1974, however, capitalization awards were to be
tax free because it was not regarded as amounts distributed for the purposes for the
definition of dividends (Divaris, 1975b:111). The Income Tax Act has subsequently been
changed to order that dividends are free of normal taxation.
South African companies who have declared capitalization awards as defined by Voogt
(1995:39) include Anglo American Platinum Corp. Ltd, Consolidated Frame Textiles Ltd,
Everite Holdings Ltd and Rustenburg Platinum Holdings Ltd (The Investors Guide,
1996:79,134,171,353).Capitalization awards have become part and parcel of the South
African economy and needs further attention. Capitalization awards will be discussed in
detail in chapter 7 of this thesis.
The Johannesburg Stock Exchange defines scrip dividends as bonus or capitalization shares
which a shareholder elects to receive in lieu of a cash dividend, where he is given the right
. to make such an election (Anderson, 1994:15). Shareholders will make a personal election
between cash and shares at the time of the payment of scrip dividends.
Chapter 6 - Rules for the payment of, and different forms of dividends 149
■
Scrip di Adends have become extremely popular in South Africa since the introduction of
STC. STC is levied at a flat rate of taxation on dividends paid. Scrip dividends are,
however, partly exempt from STC and investors would consequently receive a higher cash
equivalent from scrip dividends than investors receiving cash dividends. Some of the
companies who have announced the payment of scrip dividends include The South African
Breweries Limited, Amalgamated Banks of South Africa Limited, Amalgamated Beverage
Industries Limited, African Life Assurance, Edgars Stores Limited and Conshu Holdings
Scrip dividends have- become an important financial tool in the light of the taxation
consequences of its use. Scrip dividends will be discussed in detail in chapter 8 of this
thesis.
6.10. Summary
The decision taken by the directors of a company on the dividends that a company should
declare and pay to shareholders has to be concluded by looking at a number of rules and
issues. Cognisance should be taken of the direct and indirect rules for the calculation and
payment of dividends in the Act. The consequences of borrowing external funds in order
to pay dividends should be considered thoroughly, as well as the taxation implication of
such a step. The directors should further take restrictive covenants, if any, into account
that may be imposed on a company by providers of external funding.
The determination of the amount of dividends to be declared and paid should be followed
by a decision on the form of dividends to be paid. Some of the options available to
directors include cash dividends, bonus dividends, dividend in specie or kind or property,
share splits, capitalization awards and scrip dividends.
The dividend decisions of South African companies. have been characterised by the
utilisation of share splits, capitalization awards and scrip dividends as their use have
become fashionable from time to time. Curiously so at the time of a change in the Income
Tax Act. The first specialised form of dividends to be addressed in detail, is the payment
BIBLIOGRAPHY
CILLIERS, HS; BENADE, ML; HENNING, JJ; DU PLESSIS, JJ & DELPORT, PA 1992:
Korporatiewe reg; tweede uitgawe. Durban: Butterworths.
DIVARIS, C 1 975a: Scrip Dividend: A Blunder? Businessman's law, June 15 1975: 181-
182.
DIVARIS, C 1 975b: The Scrip Dividend. Businessman's law, February 1 1 975: 111-113.
GELLEIN, OS; SUTTON, MH & RUBIN, AM 1983: Retained Earnings and Dividends. (In:
Davidson, S & Weil, RL eds. 1 983: Handbook of Modern Accounting. New York:
McGraw-Hill.)
KIESO, DE & WEYGANDT, JJ 1986: Intermediate accounting; fifth edition. New York:
IRWIN.
PETER, L 1 977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SOUTH AFRICA (Republic). Acts, statutes etc.: Income Tax Act (Act 58 of 1962 as
amended). Pretoria: Government Printer.
Chapter 6 - Rules for the payment of, and different forms of dividends 151
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973 as
amended). Pretoria: Government Printer.
THE INVESTORS' GUIDE 1996: Issue 77. The Johannesburg Stock Exchange.
Johannesburg: The Investors' Group (Pty) Ltd.
VAN DORSTEN, JL 1993: The law of dividends in South Africa. Cape Town: Obiter
Publishers.
VOOGT, TL 1 995: The payment of scrip dividends. RAUREK Bulletin, 2/95: 38-44.
Chapter 7 - Capitalization awards 152
"It's a kind of spiritual snobbery that makes people think they can be happy without
7.1. Introduction
Prior to the enactment of Income Tax Act 85 of 1974, capitalization awards made by a
company (that was regarded as a private company for income tax purposes) to its
shareholders were always treated as dividends, unless it was paid up by means of the
application of the share premium account of the company (Divaris, 1975a:181). The
capitalization awards consequently attracted taxation in the hands of the recipient
shareholder. With effect from 1 January 1974 capitalization awards were to be free of
taxation because the issuance was not regarded as an amount distributed for the purposes
of the definition of "dividends" (Divaris, 1975b:111) in terms of the Income Tax Act (the
Income Tax Act has subsequently been changed to order that all dividends are free of
normal taxation).
Capitalization awards are issues of a specific nature and a number of definitions may be
attributed to capitalization awards.
Capitalization awards can also broadly be described as a free issue of new, fully paid-up
shares to existing shareholders proportionately to their existing shareholding. Capitalization
awards do not encompass payments in the form of cash or the assets of a company.
Capitalization awards are also known as "bonus shares", "free scrip issues" or "stock
dividends". In some cases bonus shares also embrace those occasions when a company
gives its shareholders shares in another company or where a company gives shares to its
employees in a profit-sharing scheme. The particular characteristics of bonus shares
should, therefore, be considered before categorising all such issues as capitalization
awards. The term "scrip" refers to a synonym for shares (The Concise Oxford Dictionary,
1982:944). Stock dividends is a term that is mainly used in North America (Woods,
1976:169). The New York Stock Exchange defines stock dividends as distributions of less
than 25% of the issued shares of a company, as calculated prior to the distribution of the
capitalization shares (McGough, 1993:58).
South African companies have issued shares to their shareholders in this manner.
TABLE 7.1.
SOUTH AFRICAN COMPANIES ANNOUNCING CAPITALIZATION AWARDS
o Fedsure Holdings Ltd 0 2,10 shares for every 100 shares 16/03/1995
o Macmed Health Care Ltd o 1 for every 80 ordinary shares held 12/05/1995
o Multisource Holdings Ltd 0 3 ordinary shares for every 100 held 04/11/1994
held
o Waltons Stationary Co. Ltd 0 1 ordinary share for every 100 held @ 25/01/1994
The broad spectrum of companies who have paid capitalization awards would suggest that
there may be a variety of reasons for the free issue of shares to shareholders.
Chapter 7 - Capitalization awards 155
7.4.1. Introduction
A study of British companies during the years 1968 to 1970 attempted to discover
the most important reasons for the payment of capitalization awards. The outcome
of the study showed that the main reason for the payment of capitalization awards
was to reduce the earnings rate of a company's shares to a level nearer to the
return on capital employed (Woods, 1977a:232).
The earnings rate of the shares of a company refers to the comparison of earnings
per share from one year to another or to a particular base year chosen by the
company.
"Earnings per share" is defined in AC 104 Earnings and dividends per share as the
earnings attributed to any class of equity share for a period, in cents, divided by the
Weighted average number of shares of that particular class in issue (SAICA,
1992:par .06).
"Earnings" in turn is defined in AC 104 Earnings and dividends per share as net
income for a period after taxation, outside shareholders' interests and dividends on
preference shares, but before extraordinary items and transfers to or from reserves,
including retained equity income or deficits for the period which has been equity
accounted (SAICA, 1992:par.05).
Chapter 7 - Capitalization awards 1 56
earnings per share is defined in AC 104 Earnings and dividends per share as the
period that a particular number of shares has been entitled to share in the earnings
At the time of the payment of capitalization awards, the weighted average number
of shares used in the calculation of earnings per share will increase as new shares
are issued to shareholders. Consequently, earnings per share will decrease as the
denominator in the calculation of earnings per share will increase. Moreover, if all
the other factors in the calculation of earnings per share remain stable, a year on
year comparison of earnings per share or a comparison to a chosen base year will
The decreased earnings rate of shares now have to be agreed to the return earned
frequently used ratios in financial analysis, but also one of the most ill-defined
yardsticks. The return on capital employed ratio measures the relationship between
trading profit and the capital employed in a company in order to measure efficiency
As the return on capital employed is a measure of the adequacy of the return which
shareholders a rate of return on, their investments which is equal to, or less than,
the rate of return earned on capital. An earnings rate above the return earned on
capital employed can probably not be justified by actual earnings and may not be
maintained in the long term. Dividends that are not backed up by underlying
earnings or returns of a similar growth rate, will provide artificially healthy earnings
earnings per share may be advisable in the case of companies where such earnings
Chapter 7 - Capitalization awards 157
are higher than the actual return earned on invested capital. Current and potential
investors will benefit from earnings growth which will be matched by a growth in
the return earned on capital invested. Furthermore, a company employing this tactic
may reduce future pressure on it from investors who demand a particular pattern
in the growth of earnings.
7.4.3.1. Introduction
investors will be able to get faster immediate order fulfilment (The JSE,
1994:273).
Liquidity levels on the JSE for the period 1988 to 1993 is reflected in Table
7.2. (The JSE, 1994:274). The liquidity statistics are also provided for
transactions excluding shares held in pyramid companies as these shares
rarely change hands. Pyramid companies is an important feature of the
South African economy being shares held vertically in groups of companies.
TABLE 7.2
LIQUIDITY ON THE JSE (Calender years)
TABLE 7.3.
JSE v OTHER WORLD EXCHANGES
AMOUNT JSE
Market Capitalization
Liquidity:Idomestic
Market Turnover:
(US$ billions)
Number of listed
companies:
Average Domestic
Company Size:
Fund raising
effectiveness: funds
raised by existing
companies as a % of .
Relationship to GNP:
% market capitalization
Concentration (size):
top 5% of companies
ranked by market
capitalization as a % of
Concentration (liquidity):
top 5% of companies
as a % of total trading
The comparisons were arrived at after converting the local currencies to the
US Dollar equivalent at that date. Statistics for forty-two markets were used
exchange ranked 21st for each of the measurements. The "average" is the
In general, shares on the JSE do not change hands frequently and are not
causes.
The study which was conducted on the future structure of the JSE also
importance) the causes of the poor liquidity on the JSE (The JSE,
TABLE 7.4.
PRIMARY CAUSES FOR THE LACK OF LIQUIDITY
Pyramids 2,86
Inadequate transparency and time and price priority for small investors 1,93
One of the solutions for the causes of poor liquidity on the JSE as described
in paragraph 7.4.3.3. would be to pay capitalization awards to shareholders
in order to increase the marketability of the shares.
During the period under review it was the policy of Foschini Limited to
award capitalization shares to the full value of taxed earnings. The company
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persisted with the a policy until cash dividends were paid during the 1995
financial year. The dividend cover of the company prior to the introduction
motives. Firstly, the value of the portion of the shares issued in accordance
with the company's long term sustainable dividend payout ratio was to be
that were tightly held (Everingham & Hopkins, 1995:496). From the
statistics in Table 7.5. it would appear that the company only had limited
success in this regard. Shares are now held more tightly than ever by
institutional investors.
7.4.3.6. Conclusion
reasons for this lack of liquidity is, among others, the concentration of
Peterson, Millar and Rimbey recently conducted research on the signals sent out by
The nature of the payment of capitalization awards is such that dividends are not
paid by way of cash. New fully paid-up shares are issued to shareholders who
receive nothing but additional share certificates (Woods, 1977a:233).
Whilst the company is able to retain cash in this way the company can also
maintain a good relationship with its shareholders, as the shareholders continue to
receive a form of return on their investments.
The transfer of reserves to share capital at the time of the payment of capitalization
awards may be costly for companies incorporated in some American states as cash
dividends may be limited to the amount of retained earnings (Peterson et al.,
1996:243).
The fifth justification for the payment of capitalization awards is that the share issue
may be utilised as a tool to make paid-up share capital more representative of
shareholders' funds permanently employed in a company (Woods, 1977a:233).
Chapter 7 - Capitalization awards 1 66
This scenario will be feasible when the whole of, or a portion of the accumulated
A transfer from accumulated profit to share capital at the time of the capitalization
award would bring the share capital account in line with the funds permanently
employed in a company (Woods, 1 977a:233). There are two main reasons why a
company would want to proceed along this route. These reasons are discussed
below.
The balance sheet of a company may reveal two types of reserves. The first
The Act dictates, in sections 76 and 98, that the share premium account
authority. Reserves that do not fall in any of these categories will be deemed
share capital account at the time of the capitalization award, the nature of
1977a:233).
There are two consequences to this step (Woods, 1977a:233). The first
Chapter 7 - Capitalization awards 167
from shareholders for higher dividends or from trade unions for higher wages
share capital.
the case around 1955 when some Labour politicians threatened such
forms may not be discounted outright in South Africa. The South African
a two-thirds majority. During the 1 990's after the unbanning of the African
discussed in paragraph 3.5.2. the view that the paid up share capital of a
the Courts.
company at the time of the issue of the capitalization awards would increase
benefit as current and past profit that have now been capitalized may not be
Chapter 7 - Capitalization awards 168
The sixth reason for the issue of capitalization awards is closely related to
7.4.7. Reducing the gap between market price and par value
One of the less common reasons for the payment of capitalization awards is to
reduce the gap between the market price or asset value of a share and its par value,
where the first two are higher than the par value of a share (Woods, 1977b:19). A
reduction in the market price or asset value of an individual share would result from
an increase in the number of shares in issue whilst the asset base of the company
There are generally two reasons why a company would want to reduce the gap
The first reason why a company would want to reduce the gap between the
market price and par value of its shares, is that potential investors may be
who are generally hard pressed to generate discretionary savings, let alone
invest directly on the JSE. The lower the price of shares on the JSE, the
concentration of banks in predominantly white areas and the Usury Act. The
their senior managers (Leshilo, 1996:3). The lower the market price of
shares on the JSE, the greater the possibility of achieving at least some of
these objectives.
The second reason for a reduction in the gap between the market price and
par value of shares may be that the directors of a company want to reduce
occur when new shares are sold at a price which is below the value of old
shares of the same class in the issuing company. (Such issuances are dealt
requirements that need to be met in such cases (South Africa, 1 973)). The
smaller the excess of the market price over the par value of shares, the
smaller the amount of watering that may occur. The greater the market price
capitalization awards in order to equalize the par value and net asset value
of shares.
A reduction in the difference between the market price and par value of a
share has a number of disadvantages. After the gap has been reduced,
future rights issues may be costly as the rights offer has to be underwritten.
Chapter 7 - Capitalization awards 1 70
The lower the issue price at which a rights issue is made in relation to the
market price of the old shares, the smaller the need for underwriting the
issue, since there will be a greater incentive for shareholders to take up the
rights offered to them. As the issue of shares below par value is strongly
discouraged by the Act and convention, the issue price cannot be far below
market price when the market price is not much above par, thus making
rather on preference shares than ordinary shares as was the case for most
In terms of section 193 of the Act, every member of a company owning a share has
shareholders or
affects any of the rights attached to the preference shares (South Africa,
1973).
If a company has not included any such stipulations in its articles of association the
capitalization award to ordinary shareholders. In terms of section 193 of the Act all
shares issued after 1 January 1974 have to carry voting rights (South Africa,
1973). Ordinary shareholders who will now own a greater number of shares will be
able to vote with these shares. The proportionate voting rights of preference
The capitalization award to ordinary shareholders does not contravene the Act
Chapter 7 - Capitalization awards 171
The last of the reasons that will be forwarded for the payment of capitalization
awards, relate to the status of capitalization awards in the Income Tax Act.
Capitalization awards, are dealt with in section 1 of the Income Tax Act. Section
1 of this Act defines "dividends" in detail (as was discussed in paragraph 2.2.5.).
In terms of the Income Tax Act, the following is excluded from the definition of
dividends:
the nominal value of any capitalization awards to members to the extent that
the shares have been paid up by applying the whole or a portion of the share
premium account of a company (subsection (e)) and
the nominal value of capitalization awards made to shareholders on or after
1 July 1975 (subsection (h)) (South Africa, 1 962).
Capitalization awards made on or before 30 June 1975 are dealt with separately in
the Income Tax Act in subsections (g) and (h) (i) of the definition of dividends
(South Africa, 1 962) and falls out of the ambit of this thesis.
Capitalization awards are generally excluded from the definition of dividends and are
deemed to be of a capital nature. Capitalization awards, therefore, fall out of the
ambit of normal taxation and STC (STC will be discussed in chapter 8 of this
thesis). Shareholders who receive capitalization awards, receive the awards at no
taxation cost to the company.
leg of a dividend reinvestment plan or scrip dividend has become the order of the
Chapter 7 - Capitalization awards 172
day in South Africa. Scrip dividends will be discussed in chapter 8 of this thesis.
The payment of capitalization awards entails a number of costs that need to be measured
and budgeted for before the issuance is made (Woods, 1977b:20).
The issue of capitalization awards will firstly entail clerical and printing expenses. The
announcement of the capitalization awards will, generally, be printed in newspapers in
order to inform shareholders of the forthcoming issuance. The members register of the
company needs to be updated and new share certificates with accompanying explanatory
letters printed. Postage costs have to be incurred in sending the share certificates and
letters to shareholders.
Furthermore, in terms of section 75 (2) of the Act, a company increasing its share capital
by shares of a fixed amount, shall pay to the Registrar of companies an amount of five
rand for each one thousand rand, or part thereof, by which the share capital is increased.
If the company increases the number of its shares of no par value, the company shall pay
to the Registrar an amount of five rand for each thousand rand or part thereof calculated
by multiplying the number by which shares have been increased with the value of each
share. The value of each share needs to be certified by the auditor of a company showing
the value of each issued share arrived at by dividing the number of shares issued into the
stated capital account (South Africa, 1 973). The services of an auditor come at a cost.
Just as a company needs to source the costs related to the capitalization award, so too
does the company need to find a source from which the capitalization award may be paid.
Capitalization awards may be paid from a number of sources, the first being the
Chapter 7 - Capitalization awards 173
In terms of section 76 (3) (a) of the Act, the share premium account may be used in order
to pay up unissued shares of a company to be issued to members as fully paid up
capitalization awards. Section 98 (4) also declares that the capital redemption reserve fund
of a company may be used in order to pay capitalization awards (South Africa, 1 973).
Depending on the source of the issue of the capitalization awards, a number of accounting
entries need to be passed in order to show the effect of the award in the books and
records of the issuing company.
There are two schools of thought on the value of the transfer that should be made
to share capital from the source of the capitalization award. The one school of
thought is that the par value of the new shares issues should be transferred to the
share capital accounts, whilst the second school of thought states that the fair
value of shares so issued should be transferred to the share capital accounts (Kieso
Chapter 7 - Capitalization awards 174
& Weygandt, 1986:666). American accounting literature prefers the latter view as
fair value represents the economic effect of the share issue (Needles, Anderson &
Caldwell, 1990:645).
In South Africa, there is no guidance in this regard and both options may be
followed by companies. This is evident from the difference in the wording of
capitalization award announcements which were reflected in Table 7.1. which is
encompassed in paragraph 7.3.
If a company opts for the transfer at a fair value, the most reasonable measure of
fair value is the market price of a share which is easy to determine in the case of
listed companies. The fair value that is frequehtly used is the market price at or near
the date of the declaration of the dividends.
The option chosen in determining the value of the capitalization awards, would
dictate which entries need to be recorded in the books and records of the issuing
XYZ (Proprietary) Limited has the following shareholders' equity accounts in the
records of the company prior to a capitalization award:
.Contributed capital
Ordinary share capital - R5 par value, 100 000
authorized shares, 30 000 issued R 150 000
Share premium account R 30 000
Total contributed capital R 180 000
Retained earnings R 900 000
TOTAL SHAREHOLDERS' EQUITY R 1 080 000
March 15 No entry.
Subsequent to the issuance the shareholders' equity accounts in the books and
records of the company will reflect the following:
Chapter 7 - Capitalization awards 1 76
Contributed capital
Ordinary share capital - R5 par value, 100 000
authorized shares, 33 000 issued R 165 000
There are three conclusions that may be drawn from this example being:
the total shareholders' equity of the company is unchanged before and after
the capitalization award;
the assets of the company are not reduced which will be the case in a cash
dividend payment and
the proportionate ownership in the company of any individual shareholder
is unchanged before and after the award.
The accounting entries for a capitalization award at fair value or market value is
very different to the above example.
Caprock Limited has the following shareholders' equity accounts in the records of
the company prior to a capitalization award (Needles et al., 1990:645-646):
Contributed capital
Ordinary share capital - R5 par value, 100 000
authorized shares, 30 000 issued R 150 000
Share premium account R 30 000
Total contributed capital R 180 000
Retained earnings R 900 000
of registration of March 15. The market price of the shares on February 24 was
R20 per share. The entries to record the capitalization award are as follows:
March 15 No entry.
As was the case for the example in paragraph 7.7.3., the "ordinary share capital
distributable"-account is not a current liability as there is no obligation to distribute
cash or other assets. The obligation is to issue shares to shareholders. When a
company needs to prepare financial statements between the date of the declaration
of the dividends and the distribution of the shares, the "ordinary share capital
distributable"-account should be reported as part of the equity of the company.
Subsequent to the issuance, the shareholders' equity account in the books and
records of the company will reflect the following:
Chapter 7 - Capitalization awards 178
Contributed capital
Ordinary share capital - R5 par value, 100 000
authorized shares, 33 000 issued R 165 000
There are three conclusions that may be drawn from this example being:
the total shareholders' equity of the company is unchanged before and after
the capitalization award;
the assets of the company are not reduced which will be the case in a cash
dividend payment and
the proportionate ownership in the company of any individual shareholder
is unchanged before and after the award.
The examples in paragraph 7.7.3 and 7.7.4. discussed the issue of capitalization
awards from the retained earnings of a company. There are, however, other sources
for the issuance.
The discussion in paragraph 7.6. concluded that there are three sources for the
payment of capitalizatiOn awards, being retained earnings, share premium and a
capital redemption reserve fund.
the first journal entry relating to the transfer from retained earnings will be replaced
with a debit entry from the share premium account or the capital redemption
reserve fund of a company. The composition of the equity of the company will
The examples for the payment of capitalization awards in paragraph 7.7.3. and 7.7.4.
concluded that:
the total shareholders' equity of a company is unchanged before and after a
capitalization award;
the assets of a company are not reduced as is the case in a cash dividend payment
and
the proportionate ownership in the company of any individual shareholder is
unchanged before and after the award.
As the total equity of the company has not changed after the issue of the capitalization
awards, the value of an investment in the shares of the company has not changed in total.
To illustrate the point, consider the terms of the issue of capitalization awards in paragraph
7.7.4. which is summarised in Table 7.6.
TABLE 7.6.
ACCOUNTING FOR THE RECEIPT OF CAPITALIZATION AWARDS
Consider now the case of a shareholder who owns 1 000 shares before the capitalization
award. After the 10% capitalization award, this investor would own 1 100 shares. The
book value of the investment held by this shareholder is reflected in Table 7.7.
Chapter 7 - Capitalization awards 180
TABLE 7.7.
BOOK VALUE OF THE SHAREHOLDER'S INVESTMENT
The total book value of the shares held by the investor will also be R36 000 if the
capitalization award is made at par value.
The resultant effect of the receipt of a capitalization award is that there is no accounting
entry which needs to be recorded in the books and records of the recipient shareholder.
The perception of the shareholder is, however, very different. Shareholders perceiVe to
receive an award of value in the form of dividends paid to them by way of new shares in
the company. This perception is founded on the fact that the shareholder may benefit in
the future from capital growth on the shares issued to him free of cost. Furthermore, the
additional liquidity created at the time of the capitalization award could increase the
marketability of the shares. If an investor sells his shares, he could reap an immediate
benefit from the capitalization award.
7.9. Summary
Regardless of the reasons for the issuance, capitalization awards come at a cost that
Chapter 7 - Capitalization awards 181
should be measured and taken into account in the decision-making process at the time of
the declaration of dividends.
Just as the costs of the issue of capitalization awards need to be sourced, so too does the
issue itself need to be sourced from the funds of the company. In terms of the Act and
accounting principles there are three sources for the issuance, being the distributable
reserves of a company, a share premium account or a capital redemption reserve fund.
The payment of capitalization awards may be accounted for in two ways. The first being
at the par value of the shares and the second at the market value of the shares. Although
the latter view -is subscribed to in the United States of America, both options are used in
South Africa.
The issue of capitalization awards is a very clever tool in order to provide shareholders with
a return on their investments at a relatively low cost to the company. Capitalization awards
have become the order of the day in South Africa as capitalization awards form one leg of
the payment of scrip dividends through dividend -reinvestment plans. Scrip dividends will
be discussed in chapter 8 of this thesis.
Chapter 7 - Capitalization awards 1 82
BO LIOGRAPHY
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Oxford: Heinemann Professional Publishing Ltd.
COOKE, TE 1993: The Impact of Accounting Principles on Profits: The US versus Japan.
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476.
DIVARIS, C 1975a: Scrip Dividend: A Blunder? Businessman's law, June 15 1975: 181-
182.
DIVARIS, C 1 975b: The scrip dividend. Businessman's law, February 1 1975: 111-113.
FOSCHINI 1992: 1992 Annual reports Foschini Limited, Lewis Foschini Investment
Company Limited.
GELLEIN, OS; SUTTON, MH & RUBIN, AM 1983: Retained Earnings and Dividends. (In:
Davidson, S & Weil, RL eds. 1 983: Handbook of Modern Accounting. New York:
McGraw-Hill.)
JOHNSON, THE 1983: Investment principles; second edition. Englewood Cliffs: Prentice-
Hall Inc.
KIESO, DE & WEYGANDT, JJ 1986: Intermediate accounting; fifth edition. New York:
IRWIN.
LESHILO, T 1996: Study says blacks still face many economic barriers. Business Report,
Chapter 7 - Capitalization awards 183
July 18 1996: 3.
PETER, L 1977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
'SOUTH AFRICA (Republic). Acts, statutes etc.: Income Tax Act (Act 58 of 1962 as
amended). Pretoria: Government Printer.
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973 as
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THE CONCISE OXFORD DICTIONARY 1982: seventh edition. Oxford: University Press.
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WOODS, IR 1 977a: Why are capitalization shares issued? Businessman's law, 1 August
1977: 232-233.
WOODS, IR 1 977b: The other reasons for capitalization shares. Businessman's law, 15
September 1 977: 19-21.
Chapter 8 - Scrip dividends 185
"Anybody has a right to evade taxes if he can get away with it. No citizen has a
moral obligation to assist in maintaining the government." - J. Piermont Morgan
(Peter, 1977:464).
8.1. Ontroduction
Scrip dividends paid via DRPs were first introduced in the United States of America in
1968. The first listed South African company to make use of a DRP in order to pay
dividends was Boumat Limited in 1984. The concept of scrip dividends failed to take root
in South Africa until the introduction of STC in 1993 (Everingham & Hopkins, 1994:489).
The form through which dividend payments were made changed dramatically after this
date and scrip dividends became the order of the day. In the paragraphs to follow, a wide
range of issues relating to scrip dividends will be discussed, starting with the definitions
that may be attributed to scrip dividends.
"Scrip dividends" may be defined in a number of ways. Paragraph 6.9. detailed the
Johannesburg Stock Exchange definition for scrip dividends as being bonus or capitalization
shares Which shareholders elect to receive in lieu of cash dividends where shareholders are
given the right to make such an election (Andersen, 1994:15).
DRPs through which scrip dividends are paid refer to any plan under which shareholders
are awarded capitalization shares and subsequently have a right to elect cash dividends in
Chapter 8 - Scrip dividends 186
Davies, Paterson & Wilson concurs with the previous views by stating that scrip dividends
arise when a company offers its shareholders the choice of receiving further fully paid up
shares in the company as an alternative to receiving cash dividends (1994:789).
In the early days of scrip dividends in South Africa, Divaris (1975a:111) viewed the
concept as an optional capitalization award stating that shareholders who have failed to
make an election between receiving capitalization shares and a cash dividend in terms of
such an announcement will become entitled to receive an equivalent cash amount.
To summarize, scrip dividends provide shareholders with a choice between accepting new
fully paid-up shares or cash dividends in order to earn a return on their investments in the
share capital of companies. Scrip dividends, therefore, provide shareholders with a choice,
whereas capitalization awards allow no election, only a receipt of shares. A number of
prominent South African companies have paid scrip dividends to their shareholders.
One of the first South African companies to declare a form of return which was similar to
scrip dividends was Trio-Rand (SA) Ltd. In April of 1975 Trio-Rand announced an interim
dividend payable to shareholders registered as such of ten cents for each ordinary share
which was to be paid in two cents per share cash and eight cents by way of capitalization
shares. In those early years of quasi scrip dividends, shareholders did not have a choice
between cash dividends or capitalization shares and such dividend plans took on the form
of capitalization awards rather than scrip dividends (Divaris, 1975b:181).
The recent attitude of listed South African companies has been that their dividend policies
should •be influenced strongly by taxation considerations (Everingham & Hopkins,
1994:489).0ne of the taxation considerations that has burdened South African companies
over the past three years has been the introduction of STC. Since the introduction of STC
scrip dividends have become an integral part of accounting life in South Africa as a large
number of prominent listed South African companies have opted for this approach in
paying dividends. Examples of these companies are included in Table 8.1. (The Investors'
Chapter 8 - Scrip dividends 187
Guide, 1996:72,165,201,206,223,243,287,368,419).
TABLE 8.1.
SOUTH AFRICAN COMPANIES ANNOUNCING SCRIP DIVIDEND PLANS
0 Amalgamated Banks of o 2,44 ordinary share for every 100 held 22/05/1995
South Africa or a cash dividend of 30,5 cents per
share
0 Engen Ltd o 3,1 ordinary shares for every 100 held 01/11/1994
or a cash dividend of 99,0 cents per
share
0 Haggie Ltd o 2,04 ordinary shares for every 100 held 10/08/1995
or a cash dividend of 55 cents per share
o Iscor Ltd 0 2,75 ordinary shares for every 100 held 23/08/1995
or a cash dividend of 11 cents per share
0 Liberty Life Association of o 1,33 ordinary shares for every 100 09/02/1995
Africa Ltd held or a cash dividend of 108 cents per
share
0 Nedcor Ltd El 0,83 ordinary hares for every 100 held 05/05/1995
or a cash dividend of 36 cents per share
0 Sasol Ltd ® 1,49 ordinary share for every 100 held 12/09/1995
or a cash dividend of 55,5 cents per
share
During 1993, 28 million new shares were created on the JSE as a result of scrip dividend
schemes whilst 77 million shares were created in this way during 1994 (Valentine,
1995:S1).
Companies with a broad spectrum of business objectives have implemented DRPs. One
Chapter 8 - Scrip dividends 1 88
would expect directors to have a host of reasons for issuing scrip dividends in order to
provide shareholders with a return on their investments.
.4.1. introduction
The first reason for the payment of scrip dividends is the effect of the payment on
the cash position of a company. Cash will be retained in a company to the extent
that shareholders elect to receive capitalization shares instead of cash dividends
(Divaris, 1975a:111).
An example of a prominent South African company that has benefited from a high
Chapter 8 - Scrip dividends 189
acceptance rate of capitalization shares is The South African Breweries Limited with
a capitalization share acceptance rate of 90,1% on final dividends for the year
ending 31 March 1995 (Anon., 1 995a:9). The Group Financial Review for the year
ending 31 March 1995 stated that cash retained from operations was boosted by
R354 million resulting from capitalization shares awarded in lieu of cash dividends.
Net cash retained in the group for the year ending 31 March 1995 was R1 946,1
million (The South African Breweries Limited, 1995:12), 18% of which was
contributed by the results of the DRP.
In the case of The South African Breweries Limited, the strategy to pay scrip
dividends with a very high rate of acceptance of capitalization shares is one of the
tools utilised in order to achieve the objectives of the group. Cash management is
a key focus of the group. Both working capital and a substantial portion of capital
expenditure were funded from internally generated cash (The South African
Breweries Limited, 1 995:4).
The third reason for the payment of scrip dividends is closely related to a cash
saving.
At the introduction of STC the rate at which this tax was charged was 15%.
The STC rate subsequently increased to 25% with effect from 22 June
1994 and was reduced again in the March 1996 budget to 12,5% (Bulger,
1996:1).
STC has created a tax incentive for companies in retaining, rather than
distributing corporate earnings (Thomas & Sellers, 1994:86-87) as STC will
be payable on the net amount of dividends declared.
In terms of section 64B of the Income Tax Act, the net amount of dividends
declared is calculated by identifying all dividends received by the company
since the date of declaration and deducting these dividends from the amount
of dividends declared by the company (South Africa, 1962).
Section 64B of the Income Tax Act is backed up by section 64C that was
specifically introduced as an anti-avoidance measure with the purpose of
bringing transactions between shareholders and companies by way of loans,
releases from obligations, payments to third parties or other applications of
Chapter 8 - Scrip dividends 191
funds to or for the benefit of the shareholders within the STC net (Wilson,
1994:113).
The Income Tax Act definition for dividends is used in the determination of
dividends declared on which STC is levied. Being one of the longest
definitions in the Income Tax Act, the definition also details a number of
distributions which should not be regarded as "dividends".
Capitalization awards are not regarded as dividends for the purposes of STC.
The portion of scrip dividends taken up by way of capitalization shares will
result in a direct saving of taxation in the form of STC. The value of the
saving may be material depending on the size and acceptance rate of the
offer.
The saving of R96 805 351 is calculated as follows (The South African
Breweries Limited, 1995:71,77):
STC on actual final cash dividend payments per the published results of the
DRP (Anon., 1995a:9):
Cash dividends = R 42 597 749,68
x STC at 25% = x 25%
STC paid on cash dividends = R 10 649 437,42
The difference between the STC that would have been payable on a full
cash dividend election and the STC payable on the actual final cash
dividends is F-96 805 351,22.
Net cash retained in the group for the year ending 31 March 1995 was
R 1 946,1 million of which 5% was, therefore, sourced directly from the
saving of STC (being ((R96,8 million/R1 946,1 million) x 100%).
Although the fiscus has accordingly lost valuable STC income, one would
hope that normal taxation payable on the return earned by the company on
the reinvestment of the STC saving would make up for the loss by the fiscus
of STC.
In the case of The South African Breweries Limited, one way to calculate the
taxable earnings that should be realised on the saving of STC in order for the
fiscus to make up for the loss of STC by way of normal taxation, is as
follows:
With the rate of corporate taxation in South Africa currently at a flat
rate of 35%, the R96 805 351 saving on STC has to translate into
taxable profit of R276 586 717 (R96 805 351/35%) for the fiscus
to break even. Total profit before taxation for the year ending 31
March 1995 was R2 537,5 million and cash retained from trading
profit R2 934 million.
The ratio between the STC saving and the profit goal is as follows:
STC cash saving:Profit that should be earned for the fiscus to break
even
R96,805 million:R276,587million
0.35:1
Given that profit trends in The South African Breweries group continue
current patterns, it is unlikely that the fiscus will be able to make up for the
loss of STC by way of normal taxation. As it is unlikely to be the case for
companies of the stature of The South African Breweries Limited (being one
of the largest companies on the JSE with a market capitalization of R31 653
million), it is inconceivable that the fiscus could make up for losses in STC
in lesser companies by earning sufficient taxable profits on STC savings.
A number of other reasons exist for the payment of scrip dividends. These reasons
focus on the justifications for the payment of capitalization awards. A number of
reasons for the payment of capitalization awards were discussed in paragraph 7.4.
The most controversial reason for the payment of scrip dividends relate to the
saving of STC. The Income Tax Act legislation for the implementation of DRPs is
extensive and needs careful consideration.
Chapter 8 - Scrip dividends 1 95
.5.1. Ontroduction
The payment of STC was introduced by section 64B of the Income Tax Act (South
Africa, 1962). This section, as well as amendments thereto have brought a number
of problems to the fore.
The purpose of this thesis is not to study the taxation implications of the
declaration of dividends in depth. A number of problems associated with STC will
be documented below, but will not be studied in detail.
In terms of paragraph 1 (h) of the definition for dividends in section 1 of the Income
Tax Act, the nominal value of capitalization awards are excluded from the definition
for dividends (South Africa, 1962). The question then remains whether
capitalization awards issued at market value (par value plus a premium) will be
exempt from STC.
In terms of the definition of "nominal value" in the income Tax Act, the nominal
value of capitalization shares is equal to the amount of the company's reserves and
unappropriated profits applied in paying up shares so distributed and the amount of
such reserves applied in paying up any share premium account in respect of the
capitalization shares. The issue of capitalization shares at market value will,
therefore, not attract STC (Wilson, 1994:113).
In terms of paragraph (h) of the definition for dividends in section 1 of the Income
Tax Act, capitalization awards that form part of the equity of a company is
excluded from the definition of dividends and exempt from STC (South Africa,
1962).
Chapter 8 - Scrip dividends 196
The Income Tax Act defines "equity shares" as those shares in issue excluding any
part thereof which, neither as respects dividends nor as respects capital, carries any
right to participate beyond a specified amount in a distribution (South Africa, 1962).
Equity shares would exclude preference shares.
TABLE 8.2.
EXAMPLE - WORDING OF SCRIP DIVIDEND ANNOUNCEMENT
CI Company Y declares an award of capitalization shares to its shareholders, announcing that any
shareholder who so elects may receive a dividend in cash in lieu of an issue of shares.
El Company X has declared a dividend and a liability to STC has therefore been incurred. The
award of shares to shareholders who so elects is no more a method of payment of the dividend
and while itself falling outside the ambit of a dividend it does not alter the fact that a dividend
CI Company Y on the other hand incurs no liability to STC on the declaration of the award of
capitalization shares. If it permits a shareholder who declines the award to receive a payment in
cash in lieu of the issue of shares, this payment will constitute a dividend being a distribution in
ensure that STC is not invoked at the declaration of dividends. Refer to Table 8.3.
TABLE 8.3.
EXAMPLE - SCRIP DIVIDEND ANNOUNCEMENTS
Ordinary shareholders registered in the books of Clicks at the close of business on 23 June 1995
("the last date to register") will receive 1,2 fully paid new ordinary shares of no par value for
every 100 ordinary shares held provided that such shareholders may elect to decline the award
in respect of all or part of their shareholding and instead receive a cash dividend of 3,6 cents per
ordinary share.
The number of new Clicks ordinary shares to which shareholders are entitled will be calculated
on the following basis:
New Clicks ordinary = Number of ordinary shares held at the last date to register x 1,2
share entitlement 1 100
Any fraction of a new Clicks ordinary shares award will rank for a residual cash payment based
on the issue price of 300 cents per share, which will be included in the amount to be paid as a
UAL Aksepbank Beperk is gemagtig om aan te kondig dat, in aansluiting by die aankondiging van
die resultate wat op Dinsdag, 2 Mei 1995, gepubliseer is, die direksie van die Maatskappy bepaal
het dat die uitreiking van nuwe volopbetaalde gewone aandele in die Maatskappy as 'n
vir elke 100 gewone aandele wat gehou word deur aandeelhouers wat by kantoorsluiting op
Vrydag, 26 Mei 1995, as sodanig in die boeke van die Maatskappy geregistreer is. Sodanige
aandeelhouers sal geregtig wees om ten opsigte van hulle hele of 'n deel van hulle aandelebesit
te kies om in plaas daarvan 'n eindkontantdividend van 17 sent per gewone aandeel te ontvang.
Waar die geregtigheid op nuwe gewone aandele 'n breukdeel van 'n gewone aandeel tot gevolg
het, sal sodanige breukgeregtigheid nie toegewys word nie, maar deur middel van 'n oorblywende
kontantdividend in die plek daarvan, gegrond op 'n uitgifteprys per gewone aandeel van R5,40,
Karos Hotels Limited - Capitalisation share offer and right of election to receive instead a cash
dividend
In order to conserve cash in line with the Group's expected increased working capital
requirements, the directors have resolved to distribute a capitalisation award of ordinary shares
with a par value of 40 cents each at an issue price to be determined, to shareholders of Karos
Hotels Limited who are registered in the books of the company at close of business on 7 July
1995.
Shareholders are entitled and will be given the opportunity to decline the award of capitalisation
shares in respect of all or any part of their shareholding and may elect to receive, instead, a cash
dividend of 2.65 cents per ordinary share in respect of the year ended 31 March 1995 payable
on 4 August 1995 (Anon., 1 995d: 12).
The original legislation on STC created the problem that intergroup dividends
awarded to corporate shareholders could invoke STC. This risk has subsequently
been eliminated with the 1994 Income Tax Amendment Act. The new clause is
contained in section 64B (5) (f) that states that the following shall be exempt from
STC:
"Any dividend declared by any company to any other company, if-
such other company at the date of such declaration holds for
its own benefit all the equity share capital of such company;
such other company is a company which has its place of
effective management in the Republic and its profits are
derived solely from a source within the Republic; and
such company has by notice in writing furnished to the
Commissioner by not later than the last day on which
secondary tax on companies would, but for this exemption,
have been payable in respect of the declaration of such
dividends or such later date a the Commissioner may approve,
elected that such dividend be exempt from the payment of
secondary tax on companies in terms of this paragraph"
(SAICA, 1995:6).
Chapter 8 - Scrip dividends 1 99
The decision on whether or not to make the above election requires careful
consideration. The SAICA document (1995:8) states that if an election is made in
a lower tier of the group, elections must be made in all higher tiers of the group
where the option is available. If not, the benefit of the exemption granted in respect
of earlier elections will be lost.
During 1996, section 64B (5) (f) was changed yet again to relax the exemption
which is only applicable to wholly-owned subsidiaries. Subsidiaries will still qualify
for the exemption if not more than 10% of the subsidiary's equity share capital is
held by a share incentive scheme. The share incentive scheme would include shares
held by full-time employees of the company in such a scheme and/or shares held
by a share incentive trust (SAICA, 1 996:6-7).
The STC considerations with regard to scrip dividends do not end at the time of the
declaration of dividends. The second proviso of the definition of dividends as set
out in paragraph 2.2.5. states that if ever a reduction of capital takes place that
results in a distribution to shareholders, the amount distributed will be regarded as
a dividend to the extent that the reduction is represented by previous capitalization
issues computed on a last-in-first-out basis. A purchaser of the shares of a
company, which issued capitalization shares in lieu of dividends in the past, may
be faced with a potential liability for STC (Maspero, 1994:123).
At the time of the introduction of STC the question arose whether STC was part of
the normal taxation payable by companies. AC 303 Accounting for the dual
corporate tax system (SAICA, 1993) concluded that STC is not a tax on dividends
per se but that STC forms part of the corporate tax payable by a company. STC
should be incorporated with the tax charge in the income statement thereby
reducing taxed earnings. Although this disclosure method adversely affects the
calculation of earnings per share and the dividend cover of a company the generally
Chapter 8 - Scrip dividends 200
The directors of a company may elect to pay the cash dividend portion of scrip dividends
from borrowed funds. The borrowing powers of directors may be limited in the articles of
association of a company. In terms of line 60 of Table A and line 59 of Table B of Schedule
1 of the Act, external borrowings obtained by directors may not exceed an amount which
is equal to one half of the amount of the issued share capital plus the amount of the share
premium account (if any) or of the stated capital account, unless specifically authorised by
the company in general meeting. The payment of cash dividends from borrowed funds was
discussed in paragraph 6.2.3.
The capitalization share portion may be funded from retained profits. Alternatively
capitalization shares may be funded from the share premium account of a company in
terms of section 76 (3) (a) of the Act which allows for the share premiuM account to be
applied in paying up unissued shares of the company to be issued to members of the
company as fully paid capitalization shares (South Africa, 1973).
Capitalization shares may further be sourced from the capital redemption reserve fund
created on redeeming redeemable preference shares from profits. Section 98 (4) of the Act
allows for the capital redemption reserve fund to be applied by the company in paying up
unissued shares of the company to be issued to members as fully paid-up capitalization
shares (South Africa, 1973).
Regardless of the source from which capitalization shares are paid, a new issue of shares
will be allotted to members. In terms of section 96 of the Act a company must complete
and have ready for delivery shares certificates within two months after the allotment of
Chapter 8 - Scrip dividends 201
The terms on which scrip dividends are offered to shareholders are normally quoted at a
number of shares that will be issued as capitalization awards for every 100 existing shares
held by shareholders instead of cash dividends (refer to Table 8.1.). Shareholders are
offered shares at a price which is called the strike price or cash equivalent price. The strike
price is normally below the market price of the shares in order to persuade shareholders
to receive capitalization shares instead of cash dividends. Shareholders are given the
opportunity of increasing their shareholding in a company at a discount without incurring
any transaction costs (Everingham & Hopkins, 1 994:493-494).
110
AI) ccounting foo. the p yment scrip dividends
. introduction
There are a number of approaches to accounting for the payment of scrip dividends.
The accounting treatment for all DRPs should, however, have the same goal, being
the fair presentation of the substance of the underlying transactions whether or not
the presentation corresponds with the legal form of the DRP. The purpose and
substance of each DRP will have to be assessed in order to determine the
appropriate accounting treatment (Beggs, 1995:1). The legal form of the
transactions should also be considered as it may be indicative of the purpose with
which directors institute DRPs.
Chapter 8 - Scrip dividends 202
The New Zealand Financial Reporting Standard 20 Accounting for Shares Issued
Under A Dividend Election Plan requires that shares issued under a DRP are
accounted for in accordance with the economic substance of the transaction. These
principles should be applied consistently by the company issuing the shares and by
the shareholders receiving the shares (Beggs, 1995:1). The New Zealand standard
contains the same requirements in order to account for the payment of scrip
dividends as those in FRS 4 which were discussed above.
At the time of the declaration of the scrip dividends, the dividends should be
recorded as an expense against the income statement at the full cash value. The
total of the amount of the dividends should also be recorded as a current liability
in the balance sheet if it is unclear how many shareholders will elect to receive
shares.
Chapter 8 - Scrip dividends 203
A company that has elected to pay scrip dividends for the first time, will find it
difficult to estimate which portion of the scrip dividends will be taken up in cash
and which portion will be taken up by way of capitalization awards. It may also be
unclear what the results of a DRP will be if the DRP forms part of final dividends,
since the final results of the DRP will only be known after year end. The New
Zealand Financial Reporting Standard 20 Accounting for Shares Issued Under A
Dividend Election Plan allows for an amount that may be deducted from the current
liability and credited to a share election reserve where an estimate can be made
with reasonable certainty of the amount of the dividends that will be taken up by
way of shares (Beggs, 1995:1). The intention of FRS 4 is still believed to be that
the full amount of the dividend should be declared as an expense against the
income statement at the time of the declaration (Davies et al., 1 994:790).
Accounting for interim scrip dividend issuances will be less complicated, as it will
be possible to reflect exactly which portion of dividends had been paid in the form
of cash and which via capitalization awards in the financial statements at year end.
The results should be readily available from the independent share registrars who
generally have the task of paying dividends to shareholders on behalf of the issuing
company.
At the time of the declaration of scrip dividends there is, however, no need for an
accurate estimation of the acceptance percentages of cash and capitalization
shares. An adjustment to the shareholders for dividends current liability account
need only be made when the final results of the DRP is available.
Once the DRP election has been finalized, adjusting entries should be passed in
order to correct differences that may have arisen between the value of the
anticipated and actual capitalization shares taken up (Beggs, 1995:1).
The shares issued under a DRP should be recognised by crediting the share capital
account with the par value of the shares that were issued, crediting the share
premium account with the excess of the cash equivalent price over the par value
and debiting the total of these amounts to the share election reserve, if any, that
was created at the declaration of the dividends. A company issuing shares with no
par value should credit the cash equivalent amount of the dividends to the stated
capital account (Beggs, 1995:1).
The bonus share approach propagates that the shares issued in terms of a
DRP are bonus or capitalization shares. The shareholders who accept the
award are viewed to have foregone their dividends and to have accepted
capitalization awards instead. The surplus credit on the shareholders for
dividend account is, therefore, an excess provision that should be credited
either to reserves as a direct movement (which is not permissable in South
Africa) or as a deduction from the next period's dividend expense (Hemus,
1992:305).
Companies quoted on the JSE will, however, have to take into consideration
that the Exchange calculates dividends per share by dividing the amount of
dividends in the income statement by the total number of shares in issue.
Chapter 8 - Scrip dividends 205
The bonus share approach would adversely affect a company's JSE rating
based on dividends per share.
rAl
1).; 4.3. SIC aqustrnent
Irrespective of the treatment in order to account for the surplus credit on the
shareholders for dividend account, a corresponding adjustment should be
made to the provision for the payment of STC. As STC is only payable on
cash dividends, there is no need to provide for STC on the capitalization
shares issued. This STC-provision will be overstated by a value equal to the
STC charge on the surplus credit on the shareholders for dividends account
and should be corrected accordingly.
The following detailed example will illustrate the calculations and accounting entries
in respect of a scrip dividend award by using the reinvestment approach (Anon.,
1995e:appendix to section 28).
94% of the shareholders chose the capitalization share option. R3 000 was paid out
in cash in respect of odd lots. The balance of the shareholders took the cash option.
Assuming that the capitalization issue is out of retained profit or earnings and the
reinvestment approach is followed, the accounting entries will be as follows:
Assuming that the capitalization issue is out of share premium and the reinvestment
approach followed, the accounting entries will be as follows:
In both cases the dividends per share should be disclosed as 10 cents per share.
Chapter 8 - Scrip dividends 208
A holding company that is in a position to receive scrip dividends will elect to receive either
cash dividends or capitalization shares.
The election to receive cash dividends will be accounted for as dividend income in the
income statement of the holding company (refer also to the example of The South African
Breweries Limited discussed below).
At the time of the election to receive capitalization awards, the nature of the capitalization
shares awarded to a holding company needs to be considered carefully in order to
determine the appropriate accounting treatment for the receipt (Everingham & Hopkins,
1994:490).
If the nature of the transaction is such that the capitalization award is made independent
of the normal dividend policy of the issuing company and independent of an intention of
the issuing company to provide the shareholders with a return on their investment, the
transaction does not transfer any value from the subsidiary to the holding company. The
effect being the same as if the subsidiary had made a capitalization award of shares. No
- accounting entry should, therefore, be posted in the records of the holding company as
discussed in paragraph 7.8.
If, however, the purpose of the award is to provide shareholders with a return on their
investment, the clear substance of the transaction is that a dividend had been declared and
that the shareholders had voluntarily reinvested the dividend proceeds in the company
(Everingham & Hopkins, 1994:491). The carrying value of the investment in the subsidiary
should, therefore, be debited by the cash equivalent of the shares received and dividend
income credited, as if cash dividends, and not shares, were taken up. This view is borne
out practically by note 1.9 in the 1995 annual financial statements of The South African
Breweries Limited, where it is stated that capitalization share awards received are included
in dividend income in the income statement (1995:65).
The sound economic principles underlying a DRP could translate into future profits or an
Chapter 8 - Scrip dividends 209
increase in the net asset value of the issuing company (whether via a saving in STC that
is reinvested in other projects or an increase in the marketability of the shares). The value
of the investment in a subsidiary issuing scrip dividends could, therefore, increase. This
could result in a revaluation of the subsidiary in the records of the holding company based
on the normal rules for revaluing assets. This practice is followed by The South African
Breweries Limited in note 1.3.4 of the company's 1995 annual financial statements, in
which it is declared that:
"Subsidiaries are revalued annually at underlying attributable net asset value. Other
investments are revalued annually at fair value. Fair value is determined by
reference to quoted market values or other appropriate measures; declines in value
are not adjusted if it is anticipated that these are temporary in nature" (1995:64).
After the scrip dividends have been recorded in the books and records of the issuing
companies some of the details of the DRP should be disclosed in the annual financial
statements of both companies.
The disclosure requirements in paragraph 6.2.5. is also applicable to scrip dividends. Beggs
(1995:1) suggests further that it is essential that comprehensive dividend disclosure be
provided in the financial statements of companies implementing DRPs. The following
should be disclosed:
details of the DRP;
an analysis of the dividends paid and declared in the form of cash and shares;
a note detailing the final results of the DRP which at the date of the previous
financial statements were not known, including an analysis of the cash and share
results;
the amount of proposed dividends and
an analysis of the movements in the share election reserve.
If scrip dividends are issued in a group of companies, the receiving company should also
give an analysis of the shares and cash dividends received.
Chapter 8 - Scrip dividends 210
The dividends per share paid by the issuing company should also be disclosed.
In order to comply with paragraph 42 (I) of Schedule 4 of the Act (South Africa, 1 973) as
well as paragraph .02 of AC 104 Earnings and dividends per share (SAICA, 1992), the
dividends per share in cents should be disclosed in the income statement of listed
companies.
The calculation of dividends per share is reliant on the amount of dividends paid and
secondly the number of shares in issue at the date of each dividend declaration.
The determination of the value of dividends declared in terms of a DRP is relatively easy,
being the cash equivalent amount of dividends. The cash equivalent is calculated by
multiplying the number of shares in issue at the time of the declaration with the dividends
per share that may be accepted by shareholders in the form of cash.
The number of shares in issue at the date of each dividend declaration is also quite easy
to determine as the information will be recorded in the register of members of a company.
In terms of a DRP, shareholders have the power to elect to receive a number of shares in
lieu of dividends. The number of new share so issued is not known at the time of the
declaration of the scrip dividends and in many cases it is not known before the finalization
of the financial statements. The effect of the dilution in dividends per share as a result of
the capitalization awards in terms of a DRP can often only be incorporated in the
calculation for dividends per share in the ensuing financial year.
An adjustment should then be made to the dividends per share in the following year as
paragraph .36 of AC 104 Earnings and dividends per share states the following:
"Where there has been a capitalisation issue, a bonus issue as part of a rights issue,
a share split, a share consolidation or a reduction affecting the number of shares in
issue without a corresponding refund of capital, the corresponding earnings per
share and dividends per share disclosed in respect of all earlier periods should be
proportionately adjusted" (SAICA, 1992).
Chapter 8 - Scrip dividends 21 1
12. Summary'
DRPs have become a popular tool in South Africa in order to provide shareholders with an
alternative return on their investments through electing to receive either cash dividends or
capitalization awards.
Although a number of different reasons exist for the payment of scrip dividends, DRPs
became the order of the day after the introduction of STC as capitalization awards are
exempt from STC. A high acceptance rate of capitalization shares in lieu of cash dividends
results in a STC saving and the retention of cash in a business that is clearly an incentive
for companies to award capitalization shares. It is, however, unlikely that sufficient taxable
earnings will be realised on the STC saving in order for the fiscus to make up for the loss
in tax revenue in the short term.
Scrip dividends are generally accounted for at the cash equivalent value of dividends as an
expense against the income statement of a company. At the same time a provision should
be created showing a liability owing to shareholders. At the time of the declaration of scrip
dividends, a company may elect to estimate the value of cash dividends it will probably pay
and the number of capitalization awards it will probably allot in order to create a share
election reserve equal to the value of the estimated capitalization awards to be issued. At
the finalization of the scrip dividend payments, it may come to light that a greater number
of shareholders elected to receive capitalization awards than originally anticipated. The
excess provision on the shareholders for dividends account should then be corrected. There
are two approaches in order to account for the excess provision. The first being the bonus
share approach and the second the reinvestment approach. In general, South African
companies have adopted the reinvestment approach in this regard.
A scrip dividend awarded to a holding company also needs to be accounted for. The
accounting entries in this respect should be in line with the nature of the award and the
selection made by the holding company of cash dividends or capitalization awards.
From a conceptual, theoretical accounting point of view, little has been written on scrip
dividends locally. This position is, however, bound to change, as a number of major South
Chapter 8 - Scrip dividends 212
African companies who have adopted scrip dividends are known to be committed to the
setting and maintenance of accounting standards. Companies such as The South African
Breweries Limited is bound to their accounting philosophy which reads as follows (The
South African Breweries Limited, 1995:50):
"The Group is dedicated to achieving meaningful and responsible reporting through
the comprehensive disclosure and explanation of its financial results. This is done
to assist objective corporate performance measurement, to enable returns on
investment to be assessed against the risk inherent- in (its) achievement and to
facilitate appraisal of the full potential of the Group.
The Group is committed to active participation in the setting and regular review of
accounting standards and to the development of new and improved accounting
practices. This is done to ensure that the information reported to the management
and stakeholders of the Group continues to be internationally comparable, relevant
and reliable."
The previous eight chapters have addressed a number of issues relating to dividends and
have identified a number of wide-ranging problems in this regard. Chapter 9 of this thesis
attempts to provide recommendations that may solve or alleviate some of these problems.
Chapter 8 - Scrip dividends 213
IBUOGRAPHY
ANON., 1995a: The South African Breweries Limited. Business Day, June 28 1 995: 9.
ANON., 1995b: The Clicks Group Limited. Business Day, June 19 1995: 7.
ANON., 1995d: Karos Hotels Limited. Business Day, June 23 1 995: 12.
ANON., 1995e: Section 28: Scrip dividends. Annual Accounting and Auditing Update
Seminar. Johannesburg: SAICA.
BEGGS, C 1995: Accounting for scrip dividends. TechTalk, March 1995. Johannesburg:
SAICA: 1-2.
BULGER, P 1 996: Win some and lose some in bland Budget. The Star, March 14 1996: 1.
DIVARIS, C 1975a: The scrip dividend. Businessman's law, February 1 1 975: 111-113.
DIVARIS, C 1 975b: Scrip Dividend: A Blunder?. Businessman's law, June 15 1975: 181-
182.
HEMUS, C 1992: Dividend share schemes. Accounting SA, October 1992: 304-305.
Chapter 8 - Scrip dividends 214
ICAEW, 1 994: FRS 4 Capital Instruments. Accountancy, January 1994 Volume 113: 100-
113.
MASPERO, P 1994: More on dividends, STC the hidden regulator. Tax Planning, 1994 8:
122-124.
PETER, L 1 977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SOUTH AFRICA (Republic). Acts, statutes etc.: Income Tax Act (Act 58 of 1962 as
amended). Pretoria: Government Printer.
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973 as
amended). Pretoria: Government Printer.
THE INVESTORS' GUIDE 1996: Issue 77. The Johannesburg Stock Exchange.
Johannesburg: The Investors' Group (Pty) Ltd.
THE SOUTH AFRICAN BREWERIES LIMITED 1995: Centenary annual report. March 1995.
THE SOUTH AFRICAN BREWERIES LIMITED 1996: Annual report 101st year ending 31
March 1996.
THOMAS, DW & SELLERS, KF 1994: Eliminate the double tax on dividends. Journal of
Accountancy, November 1994: 86-90.
VALENTINE, S 1995: Beurs gaan vanjaar uit sy nate bars. Beeld, 29 Mei 1 995: Si.
WILSON, I 1994: STC and capitalization issues. Tax planning, 1994 8: 113-114.
Chapter 9 - Identification of problems and recommendations thereto 216
"A problem well stated is a problem half solved." - Charles F. Kettering (Peter,
1977:408).
"The only problems money can solve are money problems. Many of the problems
the world faces today are the eventual result of short-term measures taken last
century." - Jay W. Forrester (Peter, 1 977:408).
9.1. Introduction
In many respects, new knowledge is remote from the immediate interests of the ordinary
man in the streets (Toffler,1971:149). The same could admittedly be said for this study
on dividends that is now reaching its conclusion.
The issue of dividends does, however, touch a vast number of the inhabitants of our
planet, either directly or indirectly through institutions (who, pay or receive dividends) that
employ them.
This thesis has identified a number of problems associated with the calculation, declaration
and payment of dividends. A number of these problems will be discussed in the paragraphs
to follow. A number of recommendations will also be provided that may help in solving
some of the problems that have been identified.
The second element of the definition, refers to the source from which dividends
may be paid as being either income, profit or a fund. The first problem to be
addressed in this chapter relates to these sources from which dividends may be
paid.
Problem 1 - Profit, income or a fund may be viewed as synonyms for the source
from which dividends may be paid.
Although literature from different periods and different sources have treated
particularly profit and income as synonyms, this study of accounting standards and
pronouncements, have come to the conclusion in paragraph 2.4.2. that profit,
rather than income or a fund available for distribution, should be regarded as the
source for the payment of dividends. Investors may, however, find it difficult to
distinguish between the sources from which dividends may evidently be paid when
studying different forms of literature.
The introduction of AC 103 Net profit or loss for the period, fundamental errors and
Changes in accounting policies (SAICA, 1995) has standardised the wording on the
face of an income statement. Income and profit can no longer be used as
synonyms. Companies that comply to Schedule 4 of the Act (South Africa, 1973),
should reflect the final results for the year in their income statements, as either
profit or a loss.
Although little confusion should arise in future in this regard, literature written
before the implementation of AC 103 Net profit or loss for the period, fundamental
errors and changes in accounting policies on 1 March 1995 (SAICA, 1 995:par.49)
may still cause confusion among investors.
The profit reflected in the income statement of a company, does not necessarily
reflect the amount that may legally be distributed in the form of dividends.
Paragraph 2.4.4. concluded that legally divisible profit is a calculation that has
accounting profit as a starting point. Accounting profit is then adjusted for the
effect of eight common law dividend rules that have evolved from Court cases
heard mainly in England during the period 1860 to 1920.
Chapter 9 - Identification of problems and recommendations thereto 219
Problem 2 - Accounting profit may not be equal to profit. legally available for
The shareholders of a company may be puzzled by the fact that dividends for a year
are greater than accounting profit. These investors, who may not be aware of the
eight common law dividend rules with which accounting profit may be adjusted at
the time of the calculation of dividends, may regard the declaration of the dividends
with some misgivings.
In terms of section . 286 (1) of the Act, the directors of a company are responsible
for the preparation of financial statements. In terms of section 286 (3) of the Act,
these financial statements should be set in accordance with Schedule 4 of the Act
and should comprise of a balance sheet, income statement, cash flow information
and directors' report in terms of section 286 (2) of the Act (South Africa, 1 973).
In terms of the disclosure requirements for income statements in the Act, detail
need not be provided of the sources from which dividends are paid, except in the
case of the payment of dividends from capital profit where a statement to that
effect is required.
report should, therefore, provide reasons why dividend payments may exceed
accounting profit as these reasons may not be evident from financial statements.
Disclosure in this regard will be of even greater importance when one or more of the
controversial common law dividend rules have been applied in the calculation of the
amount of dividends that may legally be paid as dividends.
9.4.1. Introductlon
The rights of directors with regard to the calculation, declaration and payment of
dividends, were discussed in paragraph 2.6.
The calculation, declaration and payment of interim dividends are generally under
the control of the directors of a company. Final dividends are usually calculated by
the directors and proposed by them, to the shareholders of the company in general
meeting. The general meeting would then vote on the declaration of final dividends,
but the amount of dividends declared, may not exceed the amount proposed by the
directors. Shareholders in companies that have accepted stipulations in their articles
of association that are similar to those mentioned above, clearly have few rights in
relation to the calculation, declaration and payment of dividends.
Problem 3 - The rights of shareholders and the prerogative of directors may differ
in the calculation, declaration and payment of dividends.
Neither the Act, nor the model set of articles of association of companies in
Schedule 1 of the Act, contain any provision regarding the rights of shareholders
in relation to dividends. Unless specific stipulations are, therefore, included in the
articles of association, the directors of a company will have full prerogative to make
dividend decisions based on their plans for a company.
Chapter 9 - Identification of problems and recommendations thereto 221
The needs of shareholders may also not necessarily be in line with the future vision
for a company as discussed in paragraph 2.6.7. The dividend rights of directors
may similarly, not be in line with the needs of shareholders.
Arguments for adherence to the Code of Corporate Practices and Conduct that is
contained in The King Report on Corporate Governance, is twofold. Firstly, there
will be greater understanding of the responsibilities of directors which will assist
them in framing and winning support for their strategies. Secondly, the standard of
corporate reporting and business conduct could be raised that would negate the
need for regulation in this regard (KPMG, 1995:5-6).
The third line of defense in the case of abuse of powers by directors will and should
always be the right of the shareholders of a company in general meeting to remove
a director in terms of section 220 of the Act (South Africa, 1973). After all,
directors receive compensation for the duties they perform while shareholders carry
Chapter 9 - Identification of problems and recommendations thereto 222
The rise in the compensation paid to directors and managers have recently come
under the spotlight. It may be possible to align the interests of directors more
closely with those of shareholders through performance based compensation. The
levels of compensation in relation to the performance of a company should be
monitored closely in order to create a culture of greater corporate care. A
remuneration committee should be appointed in this regard in accordance with
proposals in The King Report on Corporate Governance (KPMG, 1995:109),
otherwise there may still be a temptation and little penalty for board members to
increase the compensation of directors and senior executives (Mangel & Singh,
1993:349).
In recent times the directors of companies, particularly in the United Kingdom, have
been given the opportunity to participate actively in share options schemes as one
leg of their remuneration packages (Eggington, Forker & Grout, 1993:363).
Participation in share option schemes should, however, not be a guise under which
compensation is allocated to executives, by executives.
The lines of defense mentioned above, could create an adequate bridge between
the rights of shareholders and the prerogative of directors. Shareholders do,
however, have to bear in mind that directors are closely involved with the day-to-
day running of a company and need to be trusted, but also made accountable.
The second common law dividend rule was discussed in paragraph 3.6. The rule
states that accumulated losses suffered in past trading periods may be ignored in
the calculation of dividends that may legally be distributed.
Chapter 9 - Identification of problems and recommendations thereto 223
The second common law dividend rule was established in an English Court case in
1918 which was discussed in detail in paragraph 3.6.1. This precedent disregarded
the fact that accumulated losses are documented as being the negative side of the
equity of a company in accounting principles and standards. Consequently, the rule
does not require that the accumulated losses of a company be made up before
dividends are paid, in order to maintain capital. Although the application of the
second common law dividend rule goes against the accounting capital maintenance
theory and the capital maintenance theory documented in Court cases which were
discussed in paragraph 3.5.2. and 3.5.3., the rule may still be applied in practice
as there is no legal basis that would preclude its use.
rim
9.5.3. P, -commendations - Warn number 4
Section 286 (3) of the Act, requires that annual financial statements are
prepared in conformity with generally accepted accounting practice. The
expression "generally accepted accounting practice" is not defined in the
Act (Anon., 1995:section 27).
(SAICA, 1983a:appendix).
The opinion of Senior Counsel in this regard included the following points:
the question of compliance with statutory requirements remain a
matter of fact and of professional judgement to be decided upon the
merits of each case;
the existence of a statement of generally accepted accounting
practice need not necessarily be decisive and
non-compliance with statements of generally accepted accounting
practice will not necessarily constitute non-compliance with the Act
(SAICA, 1983a:appendix).
The position currently remains that little can be done to ensure that a
company complies with generally accepted accounting practice.
Amendments to section 286 (3) of the Act have, however, been drafted.
These amendments have been submitted to the Standing Advisory
Committee on Company Law. The acceptance and promulgation into law of
these proposed amendments, could have the following effect:
financial statements should be prepared in conformity with
accounting standards issued by the Accounting Practices Board (or
a similar body);
financial statements should be prepared in accordance with Schedule
4 of the Act;
annual financial statements should achieve fair presentation and
reasons for any departure from generally accepted accounting
practice should be disclosed in detail in the annual financial
statements of a company (Anon., 1995:section 27).
The proposed revised sections 286 (3) and 286 (3)A of the Act reads as
follows:
"(3) The annual financial statements of a company shall:
(a) be drawn up in conformity with Accounting Standards
as issued by the Accounting Standards Council and
Chapter 9 - Identification of problems and recommendations thereto. 225
3 (A) If the directors are of the opinion that the annual financial
statements drawn up in accordance with paragraph 3 (a)
would not ensure compliance with paragraph 3 (b), then:
The use or misuse of the second common law dividend rule, should at least
result in disclosure, subsequent to the acceptance of the amended section
286 (3).
The proposed amendments to section 286 (3) are not the only amendments
that may be made to the Act in the future.
Apart from the proposed amendments to section 286 (3 ) of the Act, the
entire Act will be redrafted in the future as discussed in paragraph 3.13. Any
Chapter 9 - Identification of problems and recommendations thereto 226
proposed legislation for Company Law, ought to make it clear that financial
statements need to conform in all respects to generally accepted accounting
practice. Departures from generally accepted accounting practice, should
only be accepted in extreme circumstances that should be clearly defined.
All departures from generally accepted accounting practice should be
disclosed in detail in financial statements.
The re-drafted Act should ensure that departures are not only disclosed by
the directors in financial statements. The report of the auditor on a set of
financial statements, should include a statement on the reasons for and
effect of, departures from generally accepted accounting practice. This
enhanced reporting by an auditor, should enhance the credibility of financial
statements, whilst providing the users of financial statements with an
opportunity to assess any deviation from generally accepted accounting
practice.
9.6.1. introduction
The third common law dividend rule which was discussed in paragraph 3.7. states
that depreciation on fixed assets may be ignored in the calculation of the maximum
amount legally available for distribution as dividends. The view of the Courts was
that depreciation was rather an accrual of profit than an expense to a company.
9.7.1. introduction
The sixth common law dividend rule which was discussed in paragraph 3.10.,
allows for the declaration of unrealised profits on the revaluation of current assets
in the form of dividends.
The nature of unrealised profit, is that it has not been converted into money.
Unrealised profit is, conceptually, not available for distribution as dividends if the
financial capital maintenance theory is adopted.
in paragraph 3.13., include stipulations that dividends may only be paid from
realised profits. The proposed re-drafting of the Act which was addressed in
paragraph 9.5.3.2. should include similar stipulations in order to prohibit the use of
the sixth common law dividend rule, in line with legislation in other countries.
The distribution of unrealised profits on current assets could be the result of drastic
measures of survival on the part of a company. The auditor of a company that has
Utilised the sixth common law dividend rule, needs to consider the implication
thereof on the feasibility of the company to continue as a going concern.
. introduction
The seventh common law dividend rule which was discussed in paragraph 3.11.,
is one of the most controversial common law dividend rules. The rule allows for the
declaration of unrealised profit on fixed asset revaluations as dividends.
Unrealised profit is conceptually, not available for distribution until such time as the
profit has been realised if the financial capital maintenance theory is adopted.
Revaluation surpluses will be realised at the time of the sale or scrapping of the
assets that have been revalued (SAICA, 1983b:par.16). The distribution of
unrealised profit on the revaluation of fixed assets is, however, a widely used
practice in South Africa as discussed in paragraph 3.11.7.
Chapter 9 - Identification of problems and recommendations thereto 230
The partial use of revaluation surpluses which was discussed in paragraph 3.11.4.
should be encouraged in accordance with AC 123 Property, plant and equipment
The application of the seventh common law dividend rule should also be disclosed
more aggressively in the financial statements of companies and monitored more
attentively by auditors. In terms of paragraph 42 (c) of Schedule 4 of the Act, a
statement should be made in the financial statements of a company if any part or
the whole of the dividends paid by a company have been sourced from capital
profits, as will be the case in the application of the seventh dividend rule (South
Africa, 1973).
9.9.1. introduction
The misuse of the common law dividend rules that were discussed in chapter 3,
may lead to a qualified audit report of the financial statements of a company.
Paragraph 3.12.3. explained that qualified audit opinions may not affect the share
price of a company.
Problem 8 - Paragraph 3.12.5. concluded that very few small, individual investors
can comprehend the full impact of the audit qualification of financial statements.
The comprehension of the qualification of financial statements on the grounds of
the misuse of any one of the eight common law dividend rules will be even more
problematic, as individual shareholders will perceive the company to be in a
favourable position because they receive dividends.
investors measure the value and prosperity of a company by the dividends and
capital growth that may be earned on share investments. The payment of dividends,
whether the financial statements are qualified or not, will remain a positive signal
to investors.
The gap between the level of understanding and comprehension of investors and
auditors of financial statements will grow and not decline at the time of the
qualification of financial statements. The study of accounting postulates and
standards is, after all, a lifelong one.
The 1994 study on the future restructuring of the JSE, put forward a
number of recommendations in order to re-define the role of the JSE in a
new South Africa. One of the recommendations specifically aimed at
emerging entrepreneurs, is that education programs should be continued and
extended to convey the principles and effect of raising capital and
for a year;
the effect and interpretation of qualified audit opinions;
the differences between the numerous forms of dividends that may
be paid to shareholders as disclosed in paragraph 6.3.;
reasons for the payment of dividends in specie, capitalization awards
The reasons for, and effect of, a qualified audit opinion should be disclosed
in sufficient detail by an auditor. This would particularly be the case when
a qualification relates to dividends. The investment decisionmaking
processes of investors are sensitive to dividend information as discussed in
paragraph 2.2.1. An auditor should considered the shareholder profile of a
company. The greater the number of small individual investors, in
particularly listed companies, the greater the importance of explaining the
reasons for the qualification in terms that may be understood by individuals
without accounting backgrounds.
The calculation of the amount legally available for distribution as dividends, is based
largely on the financial statements of a company, as discussed in paragraph 4.1.
Although the objective of a set of financial statements is to provide information
about the financial position, performance and changes in the financial position of
a company (SAICA, 1 990:par.1 2), financial statements are not perfect and may not
provide satisfactory information on dividends.
Problem 9 - The financial statements that are used in order to calculate the
Chapter 9 - Identification of problems and recommendations thereto 234
The problem defined in paragraph 9.10.2. is a very difficult one to solve. Many of
the imperfections in financial statements are indicative of the nature of financial
reporting. In order to attempt to solve the problem, the focus should be on the
directors of a company who are responsible for the preparation of financial
statements.
The directors of a company should consider the purpose with which financial
statements are used. Paragraph .14 of AC 000 Framework for the preparation and
presentation of financial statements states the following:
"Financial statements also show the results of the stewardship of
management, or the accountability of management for the resources
entrusted to it. Those users who wish to assess the stewardship or
accountability of management do so in order that they may make economic
decisions; these decisions may include, for example, whether to hold or sell
their investment in the enterprise or whether to reappoint or replace the
management" (SAICA, 1990).
Similar corporate governance models in the United Kingdom has suffered in the past
from a number of weaknesses. In particular the spread of creative accounting,
increases in business failures, the apparent ease of unscrupulous directors to
expropriate shareholders' funds, the limited role of auditors and the apparently weak
link between executive compensation and company performance. Some of the
recommendations forwarded by the Cadbury Committee on Corporate Governance
in the United Kingdom in this regard, inclUde improving information to shareholders,
continued self-regulation and a strengthening of auditor independence (Keasy &
Wright, 1993: 291).
9.11.1. Introduction
The success of the South African RDP is not dependent solely on the goals
achieved by the Government. The collective corporate decisions taken in South
Africa will have an impact on the achievement of the goals set by the RDP. The
decision on the dividend policy adopted by a company will also impact on the
internal growth rate of a company as well as on the growth rate earned by
investors. The growth rate achieved by companies and individuals will,
consequently affect the success of the RDP.
The following are some of the factors that should be considered by directors in their
'choice of a dividend policy:
This study of dividends, has focused on two specific forms of dividends that may
be paid as alternatives to cash dividends. These two forms are capitalization awards
Problem 1 1 - A host of reasons exist for the payment of capitalization awards and
scrip dividends. These reasons are generally not disclosed to the investment public.
Paragraph 7.4. discussed eight reasons for the payment of capitalization awards.
Paragraph 8.4. discussed two reasons for the payment of scrip dividends. The
directors of a company usually select the form through which dividends are paid
based on the goals of the company, rather than the goals of individual shareholders.
Although these payments are disclosed in announcements and letters to
shareholders, as well as in financial statements, reasons are generally not provided
for the issuances (refer to the exception to the rule, provided in the case of Karos
Hotels Limited in Table 8.3. in paragraph 8.5.4.).
The shareholders of a company who receive dividends in forms other than cash,
need to be empowered with sufficient information that would assist them in
understanding the reasons for these payments, advantages and disadvantages and
future implications of the awards.
Institutional investors will generally not benefit from this information as they
generally have the knowledge to understand the full implication of such issuances.
The focus of dividend disclosure should be on small individual investors.
the effect of the issuances on the book value or carrying value of the
investment of a shareholder;
the nature of the receipt that shareholders can expect to receive and
the negotiability of the dividend receipts.
Chapter 9 - Identification of problems and recommendations thereto 239
9.13.1. Ontroduction
South African companies may elect to account for the transfer to the share capital
account at the payment of capitalization awards at either the par value or the
market value of the shares. South African accounting standards have not addressed
the issue of capitalization awards.
The harmonization process is currently in the review and re - issue phase of existing
9.14.1. introduction
Paragraph 7.4.9. and 8.4.3. have highlighted the fact that capitalization awards and
scrip dividends became popular with the introduction of STC, as capitalization
awards are exempt of STC.
STC is paradoxical in two ways. Firstly, STC does not promote savings, which
South Africa needs desperately and secondly, STC puts a minor damper on the
commercial and industrial property sectors and the drive to create more jobs (Anon.,
1996:12).
Although STC is not levied on foreign companies, STC inhibits foreign investment
as it is poorly understood and not creditable as a foreign tax (Klein, 1996:1).
Chapter 9 - Identification of problems and recommendations thereto 241
Although STC was halved in the 1996 budget as discussed in paragraph 8.4.3.2.,
the principles behind the introduction of this tax should be readdressed urgently.
The prevalence of capitalization awards and scrip dividends in South Africa, has had
a serious negative effect on the STC income of the fiscus. As discussed in
paragraph 8.4.3.5., losses in STC can not be recovered in the short term through
other forms of taxation. STC should be scrapped as soon as possible.
9.15.1. Introduction
At the finalization of a DRP, the value of capitalization awards issued in lieu of cash
dividends, may exceed the anticipated value of capitalization awards. An over-
provision will then exist on the shareholders of dividends account that need to be
corrected with appropriate accounting entries.
South African accounting standards have not addressed the issue of scrip
dividends. South African companies may elect to account for an over-provision on
the shareholders for dividends account through either a bonus share approach or
Chapter 9 - Identification of problems and recommendations thereto 242
As stated in paragraph 9.1 3.3., the setting of accounting standards in South Africa,
is currently in a transitionary period. Generally accepted accounting practice in
South Africa is under review in order to harmonize South African accounting
standards with international pronouncements.
The harmonization process is currently in the review and re-issue phase of existing
accounting statements. Although it would take considerable time to initiate the
setting of additional accounting standards, scrip dividends need to be addressed as
soon as possible as the practice is currently very common in South Africa. Guidance
need to be given on the method to correct an over-provisions on the shareholders
for dividends accounts at the finalization of a DRP.
9.16. Summary
As humanity is approaching the second millennium, change is ever present and ever
increasing. It is hardly enough to highlight problems that face society and any study is
worth nought if it does not extend the thoughts of at least one human being.
Although this chapter has not attempted to list all the problems that have been identified
in this study, the most important issues have been documented in the paragraphs above,
with a number of recommendations that may aid in solving these problems. None of the
recommendations that have been forwarded are revolutionary in nature. All these
recommendations may be implemented readily.
Chapter 9 - Identification of problems and recommendations thereto 243
BIBLIOGRAPHY
ANON., 1995: Section 27: Legal Backing and the New Standard Setting Process. Annual
Accounting and Auditing Update Seminar. Johannesburg: SAICA.
ANON., 1996: No real change for home buyers. Finance Week, March 14-20 1 996: 12.
EGGINGTON, D; FORKER, J & GROUT, P 1 993: Executive and Employee Share Options:
Taxation, Dilution and Disclosure. Accounting and Business Research, Volume 23
Number 91 A Corporate Governance Special Issue 1993: 363-411.
KLEIN, M 1996: Dividend levy still a menace. Sunday Times Business Times, March 17
1 996: 1.
MANGEL, R & SINGH, H 1993: Ownership Structure, Board Relationships and CEO
Compensation in Large US Corporations. Accounting and Business Research,
Volume 23 Number 91 A Corporate Governance Special Issue 1 993: 339-350.
PETER, L 1 977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SOUTH AFRICA (Republic). Acts, statutes etc.: Companies Act (Act 61 of 1973 as
amended). Pretoria: Government Printer.
"Never try to tell everything you know. It may take too short a time." - Norman
10.1. introduction
This study of dividend rules and accounting issues relating to the payment of dividends,
has now reached its conclusion. All that remains is to put the study in the South African
context and to reflect on a number of new topics that may be researched on the issue of
dividends.
In the 1950's and the 1960's, the South African economy grew at a rate of 4,5%
per year, which was in line with many other western economies. During the
1 970's, the South African Government's role in the economy increased dramatically
under a burgeoning bureaucracy. Slow economic growth over this decade and the
1980's, caused South Africa to fall further behind its major trading partners. High
inflation, poor productivity, a high population growth rate and a shortage of skilled
manpower was the resultant effect (Manning, 1988:14).
The collapse of apartheid and the dawning of the New South Africa during the
1990's have brought with it its own opportunities and challenges. The South
African economy's most pressing reality now is its own sheer economic survival.
South Africa is currently battling with a staggering unemployment rate of 40%,
suffering a budget deficit amounting to 5% of its R118 billion gross domestic
product and must compete on world markets with nations like Brazil, Chile, South
Korea and Indonesia (Ogden, 1996:49). The issues that need to be addressed'are
undoubtedly immense.
Summary 246
The question then has to be asked if and how a study on dividends can make a
difference. The fact, however, remains that the proverbial drops eventually fill an
empty bucket. There are certainly no short-cuts if the country is to make a
successful transformation to full economic maturity (Ogden, 1996:49). Share
investments and dividends received by individual investors could go a long way in
introducing new participants into the equity market that is one of the pillars of the
South African economy.
Equity ownership in South Africa need to be democratized and filtered down to the
individuals of all population groups and income levels in order to reduce ethnic
conflict, reduce economic disparity of population groups and contribute to
development (Nyhonyha & Braithwaite, 1 996:8).
The majority of the population would, however, need assistance in this regard. The
empowerment of these individuals through information would be the starting point
as discussed in paragraph 9.9.3.1. Apart form the information and training that
Should be provided, these individuals would also need financial assistance in some
form in order to invest in shares and receive dividends.
Employee share incentive schemes could be a valuable tool that could provide the
majority of the economically active South African population, who currently do not
have access to equity capital, with the means of ownership of a portion of the
economy (Nyhonyha & Braithwaite, 1996:8).
Employee share incentive ownership programs are urgently needed in South Africa.
The excessive concentration of economic power in the hands of a small minority
must be addressed (Nyhonyha & Braithwaite, 1996:8). Individuals who have
previously not taken part in the formal economy need to be empowered in this way.
Summary 247
Employee share incentive schemes normally take on the form of a scheme in terms
of section 38 (2) (b) and section 38 (2) (c) of the Act (South Africa, 1 973).
Section 38 (2) (b) allows for a scheme through which a trust receives assistance
from a company in the form of money, for the subscription for or purchase of
shares. The trustees may then purchase shares in the company or its holding
company. The trustees will hold the shares for the benefit of the employees of the
company, including any salaried director holding a salaried employ or office in the
company (South Africa, 1973).
Section 38 (2) (c) allows for a company to provide financial assistance to persons,
other than directors, bona fide in the employment of the company with a view to
enabling those persons to purchase or subscribe for shares of the company or its
holding company to be held by themselves as owners (South Africa, 1973).
There are, however, other ways through which individuals may invest on the JSE.
Programs for future investment on the JSE, can target stokvels. Research has
shown that about 8 million people in urban townships belong to stokvels,
exchanging more than R900 million a year (Anon., 1996:4). The market
capitalization of black controlled companies on the JSE is currently R7,78 billion
(Kobokoane, 1996:3). Investment by black investors through stokvels in black
owned companies could make a significant impact on the composition of the JSE.
Summary 248
10.2.5. Conclusion
This thesis on dividend rules and accounting issues relating to the payment of
dividends has researched a number of aspects, highlighted a number of problems
and provided a number of recommendations. The are a number of new topics that
may be researched as a result of this study.
This study of dividends could result in the study of a number of related topics. These
topics include the following:
the study of employee share incentive schemes in South Africa;
the study of executive compensation in the form of share option schemes;
the review of a re-drafted Companies Act;
the study of other problems that individual shareholders may face and
the study of the success of information and training programs for previously
disadvantaged individual shareholders.
► 0.4. Suring-navy
Dividends may provide in some of the needs of individuals as discussed in paragraph 1.1.
This study highlighted that dividend rules and accounting issues relating to the payment
of dividends is, however, not an easy topic to understand.
The continued documentation of dividend information and the continued search for
answers and recommendations in this regard, should not be limited to one thesis, or one
academic, or one group of people. Dividends should remain an issue of concern for the
Summary 249
directors of companies, the JSE, the Standing Advisory Committee on Company Law and
Government.
Summary 250
BIBLIOGR PHY
ANON., 1996: Stokvels 'play a vital role'. Star Business Report, January 12 1996: 1.
KOBOKOANE, T 1996: Black looks beautiful in JSE's rally. Sunday. Times, February 18
1996: 3.
MANNING, AD 1988: Business Strategy in the New South Africa. Southern Book
Publishers: Halfway House.
NYHONYHA, L & BRAITHWAITE, LN 1996: Katz proposals offer scant relief to share
incentive schemes. Business Day, February 2 1 996: 8.
OGDEN, C 1996: While Mandela is an extraordinary leader who inspires confidence and
calm, he has also become an overadulated icon. Time, September 16 1996: 48-53.
PETER, L 1977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.
SOUTH AFRICA (Republic). Acts, statutes etc: Companies Act (Act 61 of 1973 as
amended). Pretoria: Government Printer.