DIVIDEND RULES AND ACCOUNTONG ISSUES 1ELATING TO

THE PAYMENT OF DIVIDENDS IN SOUTH AFRfiCA

by

UEA LOUISA VOOGT

Submitted in fulfilment of the requirements for the degree

MASTER OF COMMERCE

in

ACCOUNTING

in the

FACULTY OF ECO 0 IC AND NA''GEr EsNT SCENCES

at the

RAND AFRKAANS UNllVERSOTY

SUPERMOR: D. N. STEGMANN

MOVE IV ER 1996 Hierdie verhandeling is opgedra aan my man Re. Re, ek sou nie die harde werk kon volhou sonderjou toegewyde ondersteuning en liefde nie.

This thesis is dedicated to my husband Re. Re, without your committed support and love / would never have been able to continue the hard work. ACKNOWLEDGEMENTS

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

inwerkingtreding van Sekondere Belasting op Maatskappye in 1993, aangesien kapitalisasie aandele vrygestel is van Sekondere Belasting op Maatskappye. Hierdie verhandeling 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 genoegsame kennis oor rekeningkundige standaarde, finansiele ontleding, beleggingsbestuur en aandeelhouersregte het nie, behoort dividende meer aandag te geniet van die kant van die Beurs en van die kant van individuele maatskappye af. Hierdie groepe moet beleggers bemagtig deur genoegsame inligting in hierdie verband te openbaar.

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

ONDEX Page number

CHAPTER 1 - INTRODUCTION 1

1.1. Motivation for this study 1 1.2. Purpose of this study 3 1.3. Contents of this thesis 3 1.3.1. Chapter 2 - A definition for dividends 4 1.3.2. Chapter 3 - Profit available for distribution as dividends 4 1.3.3. Chapter 4 - Imperfections in financial statements 5 1.3.4. Chapter 5 - Dividend policies 5 1.3.5. Chapter 6 - Rules for the payment of, and different forms of 5 dividends 1.3.6. Chapter 7 - Capitalization awards 6 1.3.7. Chapter 8 - Scrip dividends 6 1.3.8. Chapter 9 - Identification of problems and 7 recommendations thereto 1.3.9. Chapter 10 - Summary 7 Bibliography 8

CHAPTER 2 - A DEFINITION FOR DIVIDENDS 9

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

2.4.2. Accounting definitions for profit, income or a fund 23 2.4.3. The income concept 26 2.4.3.1. Syntactical income 26 2.4.3.2. Semantical income 27 2.4.3.3. Pragmatic income 28 2.4.3.4. Conclusion 28 2.4.4. Legally divisible profit 28 2.4.5. Conclusion 30 2.5. Made to shareholders 30 2.6. Authorised by the board of directors 31 2.6.1. Directors' legal rights and obligations 31 2.6.2. The stewardship duties of directors 32 2.6.2.1. Duty of loyalty 33 2.6.2.2. Duty of care and skill 34- 2.6.2.3. Duty of attention 34 2.6.3.. Management clause in the articles of association 34 2.6.4. Financial and treasury management 35 2.6.5. Fiduciary duties of directors 36 2.6.6. Responsibilities of directors 37 2.6.7. Shareholders' rights v directors' prerogative 40 2.6.8. Shareholder rights movements in Europe 42 2.6.9. Conclusion 43 2.7. Summary 44 Bibliography 45

CHAPTER 3 - PROFIT AVAILABLE FOR DISTRIBUTION AS DIVIDENDS 48

3.1. Introduction 48 3.2. Principles applied in Court cases on dividend matters 49 3.3. The principle of capital maintenance 49 3.4. Common law rules 51 3,5. Rule 1 - Dividends may not be paid out of share capital 53 3.5.1. Introduction 53 3.5.2. Capital maintenance 53

Index

3.5.3. South African case law 54 3.5.4. Exceptions to the capital maintenance principle 55 3.5.5. Conclusion 56 3.6. Rule 2 - Accumulated losses suffered in past trading periods may be ignored 58 3.6.1. Introduction 58 3.6.2. The nature of accumulated losses 58 3.6.3. Effect of accumulated losses on the capital fund of a company 60 3.6.4. Accumulated losses v retained earnings 61 3.6.5. Dividing results into trading periods 62 3.6.6. The advantage to an investor 62 3.6.7. Conclusion 63 3.7. Rule 3 - Provision for losses on fixed capital and depreciation of fixed capital 64 may be ignored 3.7.1. Introduction 64 3.7.2. The nature of fixed capital 65 3.7.3. The nature of losses 66 3.7.4. The nature of depreciation 67 3.7.4.1. Depreciation as a cost allocation 67 3.7.4.2. Depreciation as a means of revaluing assets 69 3.7.4.3. Depreciation as a means of reserving funds for 69 the replacement of assets 3.7.4.4. Conclusion 70 3.7.5. The rule in perspective 71 3.7.6. Conclusion 72 3.8. Rule 4 - Losses on circulating or working capital should be taken into 72 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

3.11.3. Accounting recognition of the common law rule 79 3.11.4. Accounting guidelines for fixed asset revaluations 79 3.11.5. Realisation of surpluses on the revaluation of fixed assets 82 3.11.6. Legality of the application of the common law rule 83 3.11.7. Practical application of the rule 83 3.11.7.1. Introduction 83 3.11.7.2. A synopses of the history of the Masterbond 84 group of companies 3.11.7.3. Revaluation of the assets of the Masterbond group 85 3.11.8. Conclusion 86 3.12. Rule 8 - The financial position of a company as a whole should be 87 considered 3.12.1. Introduction 87 3.12.2. Consequences if the rule is broken 88 3.12.3. Effect of media disclosure of qualified audit opinions 88 3.12.4. Effect of qualified audit opinions on the auditor 89 3.12.5. Conclusion 90 3.13. Status of the rules in England 90 3.14. Summary 91 Bibliography 94

CHAPTER 4 - IMPERFECTIONS IN FINANCIAL STATEMENTS 98

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

4.3.4.4. Comparability 104 4.3.5. Conclusion 105 4.4. Enhancing profit at the expense of the balance sheet 105 4.4.1. Introduction 105 4.4.2. Changes to depreciation policies 106 4.4.3. Capitalization of interest 107 4.4.4. Accounting for goodwill 108 4.4.5. Brand accounting 108 4.5. The difference between profit and cash 109 4.6. Monetary expression 110 4.7. Simplification and summarisation 111 4.8. Inflation 111 4.9. Abnormal and exceptional items 113 4.10. Summary 113 Bibliography 115

CHAPTER 5 - DIVIDEND POLICIES 117

5.1. Introduction 117 5.2. Dividend policy options 117 5.3. Residual dividend policy 118 5.3.1. Characteristics of the policy 118 5.3.2. Advantages and disadvantages of the residual dividend 119 policy 5.4. Constant or steadily increasing dividends 120 5.4.1. Characteristics of the policy 120 5.4.2. Advantages and disadvantages of a constant or steadily 121 increasing dividend policy 5.5. Constant payout policy 122 5.5.1. Characteristics of the policy 122 5.5.2. Advantages and disadvantages of a constant payout ratio 122 5.6. Stable dividend growth rate 122 5.6.1. Characteristics of the policy 122 5.6.2. Advantages and disadvantages of a stable dividend 123 Index viii

growth rate policy 5.7. Low regular dividend plus extra 124 5.7.1. Characteristics of the policy 124 5.7.2. Advantages and disadvantages of a low regular dividends - 125 plus extra policy 5.8. Dividend irrelevance 125 5.8.1. Characteristics of the policy 125 5.8.2. The Stewart opinion 126 5.8.3. The Stern opinion 127 5.8.4. Practical application of the policy 127 5.9. The selection of an appropriate dividend policy 128 5.10. The Reconstruction and Development Program 129 5.11. The effect of dividend policy decisions on the RDP 131 5.12. Summary 131 Bibliography 133

CHAPTER 6 -RULES FOR THE PAYMENT OF, AND DIFFERENT FORMS OF 135 DIVIDENDS

6.1. Introduction 135 6.2. Rules for the payment of dividends 135 6.2.1. Introduction 135 6.2.2. Dividend rules in the Companies Act 135 6.2.2.1. Risk of personal liability for directors 137 6.2.2.2. Purpose of the dividend payment 137 6.2.2.3. Limitation on borrowing powers of directors 138 6.2.3. Obtaining external funds in order to pay dividends 138 6. 2.4. Restrictive loan covenants 140 6.2.5. Disclosure requirements 140 6.2.6. Conclusion 141 6.3. Different forms of dividend payments 142 6.4. Cash dividends 142 6.5. Bonus dividends 143 6.6. Dividends in specie or kind or property 144

Index ix

6.7. Share splits 145 6.7.1. The nature of share splits 145 6.7.2. Companies Act requirements for share splits 146 6.7.3. Disadvantages of share splits 147 6.7.4. Advantages of share splits 147 6.7.5. Accounting for share splits 147 6.7.6. The prevalence of share splits in South Africa 147 6.8. Capitalization awards 148 6.9. Scrip dividends 148 6.10. Summary 149 Bibliography 150

CHAPTER 7 - CAPITALIZATION AWARDS 152

7.1. Introduction 152 7.2. Definitions for capitalization awards 152 7.3. The prevalence of capitalization awards in South Africa 154 7.4. Reasons for the payment of capitalization awards 155 7.4.1. Introduction 155 7.4.2. Reducing the rate of earnings 155 7.4.3. Improving the marketability of shares 157 7.4.3.1. Introduction 157 7.4.3.2. Liquidity on the JSE 157 7.4.3.3. Causes for the poor liquidity on the JSE 160 7.4.3.4. A solution for the lack of liquidity 161 7.4.3.5. Example - Foschini Limited 162 7.4.3.6. Conclusion 164 7.4.4. Signalling earnings potential 164 7.4.5. Conserving cash 165 7.4.6. Making share capital representative of funds permanently 165 employed 7.4.6.1. The nature of reserves (reason 1) 166 7.4.6.2. Increased creditworthiness (reason 2) 167 7.4.7. Reducing the gap between market price and par value 168

Index

7.4.7.1. High share prices (reason 1) 168 7.4.7.2. Reducing. watering of shares (reason 2) 169 7.4.8. Reducing the rights of preference shareholders 170 7.4.9. Taxation considerations 171 7.5. The cost of capitalization awards 172 7.6. Sources for capitalization awards 172 7.7. Accounting for the payment of capitalization awards 173 7.7.1. Nature of the accounting entries 173 7.7.2. Value of the transfer 173 7.7.3. Example - capitalization awards at par value 175 7.7.4. Example - capitalization awards at fair value 176 7.7.5. Accounting for capitalization awards other than 178 from retained earnings 7.8. Accounting for the receipt of capitalization awards 179 7.9. Summary 180 Bibliography 182

CHAPTER 8 - SCRIP DIVIDENDS 185

8.1. Introduction 185 8.2. Definitions for scrip dividends 185 8.3. The prevalence of scrip dividends in South Africa 186 8.4. Reasons for the payment of scrip dividends 188 8.4.1. Introduction 188 8.4.2. The effect of scrip dividends on the cash position of a 188 company 8.4.3. Saving on STC 189 8.4.3.1. The introduction of STC 189 8.4.3.2. The nature of STC 190 8.4.3.3. The calculation of the net amount of dividends declared 190 8.4.3.4. Exclusions from the definition of "dividends" 191 8.4.3.5. Example - The South African Breweries Limited 192 8.4.4. Other reasons for the payment of scrip dividends 194 8.5. STC issues to consider at the payment of dividends 195

Index xi

8.5.1. Introduction 195 8.5.2. Nominal value of shares 195 8.5.3. Equity classification of capitalization awards 195 8.5.4. Wording of the scrip dividend announcement 196 8.5.5. Intergroup scrip dividends 198 8.5.6. Effect on future reductions of capital 199 8.5.7. Disclosure of STC 199 8.6. Companies Act requirements 200 8.7. Scrip dividend terms 201 8.8. Accounting for the payment of scrip dividends 201 8.8.1. Introduction 201 8.8.2. International pronouncements 202 8.8.3. Accounting entries at the date of the declaration of scrip 202 dividends 8.8.4. Accounting entries at the finalization of the DRP 203 8.8.4.1. The bonus share approach 204 8.8.4.2. The reinvestment approach 205 8.8.4.3. STC adjustment 205 8.8.4.4. Approach adopted in South Africa 205 8.8.5. Detailed example - accounting for scrip dividends 206 8.9. Accounting for scrip dividends received by a holding company 208 8.10. Disclosure requirements 209 8.11. Dividends per share 210 8.12. Summary 211 Bibliography 213

CHAPTER 9 - IDENTIFICATION OF PROBLEMS AND RECOMMENDATIONS 216 THERETO

9.1. Introduction 216 9.2. Problem number 1 - The payment of dividends from profit, or income 216 or a fund 9.2.1. Introduction 216 9.2.2. Defining problem number 1 217

Index • xii

9.2.3. Recommendations - problem number 1 217 9.3. Problem number 2 - Profit legally available for distribution as dividends 218 9.3.1. Introduction 218 9.3.2. Defining problem number 2 219 9.3.3. Recommendations - problem number 2 219 9.4. Problem number 3 - Dividend payments are authorised by the board of 220 directors 9.4.1. Introduction 220 9.4.2. Defining problem number 3 220 9.4.3. Recommendations - problem number 3 221 9.5. Problem number 4 - Accumulated losses in past trading periods may be 222 ignored 9.5.1. Introduction 222 9.5.2. Defining problem number 4 223 9.5.3. Recommendations -problem number 4 223 9.5.3.1. Redrafting of section 286 (3) of the Act 223 9.5.3.2. Redrafting of the Act 225 9.5.3.3. Harmonisation and internationalization of South 226 African Company Law 9.6. Problem number 5 - Depreciation may be ignored in the calculation of 227 Profit available for distribution as dividends 9.6.1. Introduction 227 9.6.2. Defining problem number 5 227 9.6.3. Recommendations - problem number 5 227 9.7. Problem number 6 - Unrealised profit on the revaluation of current 228 assets may be declared a dividends 9.7.1. Introduction 228 9.7.2. Defining problem number 6 228 9.7.3. Recommendations - problem number 6 228 9.8. Problem number 7 - Unrealised profit on the revaluation of fixed assets 229 may be declared as dividends 9.8.1. Introduction 229 9.8.2. Defining problem number 7 229 9.8.3. Recommendations - problem number 7 230

Index xiii

9.9. Problem number 8 - Interpretation of qualified audit opinions 231 9.9.1. Introduction 231 9.9.2. Defining problem number 8 231 9.9.3. Recommendations - problem number 8 232 9.9.3.1. JSE training programs 232 9.9.3.2. Expansion of an audit report 233 9.10. Problem number 9 - Imperfections in financial statements 233 9.10.1. Introduction 233 9.10.2. Defining problem number 9 233 9.10.3. Recommendations - problem number 9 234 9.11. Problem number 10 - The selection of an appropriate dividend policy 236 9.11.1. Introduction 236 9.11.2. Defining problem number 10 236 9.11.3. Recommendations - problem number 10 236 9.12. Problem number 11 - Reasons for alternatives to cash dividends 237 9.12.1. Introduction 237 9.12.2. Defining problem number 11 238 9.12.3. Recommendations - problem number 11 238 9.13.- Problem number 12 - Accounting for the payment of capitalization awards 239 9.13.1. Introduction 239 9.13.2. Defining problem number 12 239 9.13.3. Recommendations - problem number 12 239 9.14. Problem number 13 - The effect of STC on dividend payments 240 9.14.1. Introduction 240 9.14.2. Defining problem number 13 240 9.14.3. Recommendations - problem number 13 241 9.15. Problem number 14 - Accounting entries at the finalization of a DRP 241 9.15.1. Introduction 241 9.15.2. Defining problem number 14 241 9.15.3. Recommendations - problem number 14 242 9.16. Summary 242 Bibliography 243

Index xiv

CHAPTER 10 - SUMMARY 245

10.1. Introduction 245 10.2. The position of this study in the South African economy 245 10.2.1. The state of the South African economy 245 10.2.2. Democratizing equity 246 10.2.3. Employee share incentive schemes 246 10.2.4. Individual buying power 247 10.2.5. Conclusion 248 10.3. New research topics 248 10.4. Summary 248 Bibliography 250 Index xv

INDEX TO T 3LES Page number

1.1. Maslow's hierarchy of needs 1 2.1. Profit in the income statement of companies 29 2.2. Dividends as a key driver in analysing a company 36 2.3. Classical corporate governance model 39 3.1. Return on capital formula 57 3.2. T-account - Retained earnings 60 3.3. Usko Limited profit history 63 3.4. Depreciation v Dividends 71 3.5. English Companies Act of 1980 - Section 39 91 3.6. Summary - Common law dividend rules 93 4.1. Accounts, balances or values referred to by the common law dividend 99 rules 4.2. Example - Change to depreciation policy 107 4.3. Ten questions designed to enable analysts to assess a company's 110 cash flow statement 4.4. Factors affecting the ability to pay dividends 112 5.1. Example - Residual dividend policy 119 5.2. The South African Breweries Limited 123 Dividend policy and objectives 5.3. The South African Breweries Limited 124 Dividends v Earnings in cents per share 5.4. The South African Breweries Limited 128 Stakeholder achievement appraisal 5.5. The Foschini group 129 Contribution to the nation 6.1. Example - Dividends in specie 145 7.1. South African companies announcing capitalization awards 154 7.2. Liquidity on the JSE (Calender years) 158 7.3. JSE v Other world exchanges 159 7.4. Primary causes for the lack of liquidity 161 7.5. Foschini Limited - Share analysis at 31/3 163 Index xvi

7.6. Accounting for the receipt of capitalization awards 179 7.7. Book value of the shareholder's investment 180 8.1. South African companies announcing scrip dividend plans 187 8.2. Example - Wording of scrip dividend announcements 196 8.3. Example - Scrip dividend announcements 197 Chapter 1 - Introduction 1

CHAPTER 1 - INTRODUCTOOM

"Neither man nor nation can exist without a sublime idea." - Feodor Dostoevski (Peter, 1977:258).

1.1. Motivation far this study

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

Is Self-actualization - fulfilment of personal potential

® Esteem needs -for independence, recognition, status, respect from others

s Love/ social needs -for relationships, affection, belonging

El Safety needs -for security, order, predictability, freedom from

threat

0 Physiological needs -food, shelter Chapter 1 - Introduction 2

At the self-actualization level, individuals would probably have surplus means to be reinvested, in order to create additional wealth in order to fulfil their personal potential

(Puxty & Dodds, 1 988:3).

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).

At the point of reinvestment an investor may elect to make a relatively risk-free investment, for example in a savings account with a reputable bank or in government bonds. The alternative is to invest in investments that carry a higher degree of risk. An option that is utilised freely in this respect is investing in the shares of companies on the stock market. Investments on the stock market is not limited to individuals. Companies, as corporate investors will also invest on the stock market (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

SA ICA)declare in AC 104 Earnings and dividends per share that: "The presentation of earnings and dividends per share assists users of financial statements to assess a company's current performance and to compare it with its performance in prior periods" (1992:par.01).

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.

1.2. Purpose of this study

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.

11.3. Contents of this thesis

The motivation and purpose of this study which was documented above, can not be Chapter 1 - Introduction 4

accepted without detail consideration. Consideration will be given to a host of dividend related issues which will be encompassed in a number of chapters.

1.3.11. Chapter 2 - definition for dividends

Chapter 2 of this thesis will be devoted to the documentatidn of a number of diverse definitions for "dividends". The similarities in these definitions will form the basis for the documentation of a single definition for dividends for the purposes of this thesis. Each of the elements of the definition will be studied critically in order to identify a number of problems that may be encountered in the decisionmaking process to determine the value of profit available for distribution as dividends.

11.3.2. Chapter 3 - Profit availabOe for distribution as dividends

Chapter 3 will address the calculation of "profit available for distribution as dividends". The calculation of profit legally available for distribution as dividends is based on the accounting principle of capital maintenance and a number of common law rules that have evolved in court cases heard mainly in England in the years 1860 to 1920.

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.

The calculation of profit available for distribution as dividends will be based on information available in the books and records of a company. These books and records will be summarised in the form of financial statements. Chapter 1 - Introduction 5

11.3.3. Chapter 4 - imperfections in financial statements

The dividend decision will be based largely on the financial statements of companies. Financial statements may, however, not meet the needs of a company in this regard as explained in paragraph .13 of AC 000 Framework for the preparation and presentation of financial statement: "...financial statements do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not necessarily provide non-financial information" (SAICA, 1990).

Chapter 4 studies the impact of a number of imperfections in financial statements on the calculation of profit legally available for distribution as dividends.

1.3.4. Chapter 5 - Dividend policies

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

further restrictions on a dividend declaration.

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.

1.3.6. Chapteu 7 - CaOtaDization awavds

Chapter 7 introduces capitalization awards as a form of dividends that may be paid to shareholders. The issue of capitalization awards, as a form of return on the investment in shares, became a feature of dividend decisions in 1974 with the introduction of the Income Tax Act 85 of 1974. This section declared that capitalization awards were to be tax free in the hands of recipient shareholders (Divans, 1975:181).

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.

The introduction of Secondary Tax on Companies (hereafter referred to as STC) during 1993, saw a resurgence in the payment of capitalization awards, but in a specialized form, called scrip dividends.

1.3.7. Chapite - Scuip dvidends

The payment of scrip dividends, refer to capitalization shares received by shareholders in lieu of cash dividends at the time of a dividend declaration (Andersen, 1994:15). Whereas shareholders only receive additional shares at the time of a capitalization award, shareholders may choose whether they would want to receive cash or additional shares at the time of a scrip dividend award. The portion of the dividends that have been paid via capitalization awards, is free of Chapter 1 - Introduction 7

STC that is levied on dividends declared to shareholders in terms of section 64B of the Income Tax Act (South Africa, 1962)-

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.

1.3.. Chapter 9 - identification of probiems and recommendations thereto

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.

1.3.9. Chapter 10 - Surnmary

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.

ANDERSEN, RC 1994: Dividend shares. Financial Mail, December 9 1 994: 15.

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.

PETERSON, CA; MILLAR, JA & RIMBEY, JN 1996: The Economic Consequences of Accounting for Stock Splits and Large Stock Dividends. The Accounting Review, Volume 71 Number 2 April 1996: 241-253.

SOUTH AFRICA (Republic). Acts, statutes etc.: Income Tax Act (Act 58 of 1962 as amended). Pretoria: Government Printer.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANT 1990: AC 000 Framework for the preparation and presentation of financial statements. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1992: AC 104 Earnings and dividends per share. Johannesburg: SAICA. Chapter 2 - A definition for dividends 9

CHAPTER 2 - A DEFI1NMON FO DOV11DENDS

"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. Definitions fog. 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

that of previous years. The dividend yields of companies quoted on the Chapter 2 - A definition for dividends 10

Johannesburg Stock Exchange are printed in newspapers and periodicals, again emphasising the importance of dividends. Dividends per share ratios are also used extensively by serious investors and the business community as a guideline for future investments (The Investors' Guide, 1996:2). As the users of financial statements include present and potential investors, employees, lenders, suppliers, other trade creditors, customers and their agencies as well as the public (SAICA, 1990:par.9) one would expect a myriad of definitions for dividends.

2.2.2. Linguistic and ilegai definitions

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 Halsbury's Laws of England defines dividends as a portion of profit, whether at a fixed rate or otherwise, allocated to the shareholders of a company not by way of remuneration for services (Van Dorsten, 1993:26). Black's Law Dictionary defines dividends as a fund to be divided, that is the portion allotted to each of several persons entitled to participate in a division of profits or property, therefore a fund set apart by the corporation out of its profits, to be apportioned among the shareholders (Van Dorsten, 1993:25).

2.2.3. ccounting definitions

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

dividends gives nothing away of the intricacies of the determination of the maximum amount available for the payment of dividends and the rules involved therein.

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).

2.2.4. Definitions off the Couvts and the Companies Act

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

registration and incorporation of companies. "Shares" are defined as the share capital of that particular company that includes stock. Stock is, however, not defined by the Act.

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.

2.2.5. The Oncome Tax Ac definiVon

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

in relation to a company that is not being wound up or liquidated, any profits distributed, whether in cash or' otherwise, and whether of a capital nature or not, including an amount equal to the nominal value, at the time of issue thereof, of any capitalization shares awarded to shareholders and the nominal value of any bonus

debentures or securities awarded to shareholders; in the event of the partial reduction or redemption of the capital of a

company, so much of the sum of any cash and the value of any

asset (liven to a shareholder as exceeds the cash equivalent of the

amount by which the nominal value of the shares of that shareholder

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 - the nominal value of any capitalization shares awarded to a shareholder to the extent to which such shares have been paid up by means of the application of the whole or any portion of the share

premium account of a company; or subject to the provisions of the second proviso to this definition, any cash and the value of any asset given to a shareholder to the extent to which the cash and the value of the asset represents a reduction of the share premium account of a company; or so much of the nominal value of any capitalization shares awarded to shareholders on or before 30 June 1975 as part of the equity share capital of a company by a company which during the period of ten years ending the day before the date of such award has made any partial reduction of its paid-up share capital involving a distribution to shareholders of cash or other assets, as exceeds the sum of the amounts which were available for distribution to shareholders on each and every date on which the company made a partial reduction of its paid-up share capital during the said period, less the sum of so much of the nominal values of all capitalization Chapter 2 - A definition for dividends 14

shares awarded by such company during that period (excluding any portion of that period occurring prior to 1 July 1 957) as constituted dividends for the purposes of this definition or the definition of 'dividend' in section 1 of the Income Tax Act, 1941: Provided that for the purposes of this paragraph the amount available for distribution on any date on which the company made a partial reduction of its paid-up share capital shall, if that amount exceeds that nominal amount of such reduction, be deemed to be an amount equal to such nominal amount; or (h) the nominal value of any capitalization shares awarded to shareholders as part of the equity share capital of a company, if - such shares are or were awarded on or before 30 June 1975 and during the period of ten years ending the day before the date of such award the company has not made any partial reduction of its paid-up share capital involving a distribution to shareholders of cash or other assets; or such awards are awarded on or after 1 July 1975; (i) (i) any amount distributed by any co-operative society or company referred to in section 27 by way of a bonus out of its profits for any year of assessment of such society or company commencing before 1 April 1977, if such amount is divided among the members according to the value of the business transactions between the society or company and the members and is distributed not later than twelve months after the end of such year of assessment; (ii) any amount distributed by such society or company by way of a bonus, to the extent that such amount is allowable as a deduction from the income of such society or company under provisions of section 27; and (iii) any amount distributed out of the stabilization fund referred to in section 27 (2) (h): Chapter 2 - A definition for dividends 15

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

(bb) to the extent that subparagraph (aa) does not apply, to be a profit which is not of a capital nature and is 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 which are not of a capital nature would be entitled to participate in such a distribution, regardless of whether in either case the company in fact has or has not any profits available for distribution; Chapter 2 - A definition for dividends 16

(ii) where the share capital of the company consists of different classes of share capital, any amount deemed by paragraph (i) of this proviso to be available for distribution to shareholders shall, in applying that paragraph, be apportioned between such classes of share capital in accordance with the rights of the holders of the corresponding classes of shares to participate in distributions of profits of a capital nature or profits which are not of a capital nature, as the case may be, and the amount deemed by the said paragraph to be available for distribution to the shareholders in respect of any such class of shares shall be the amount allocated to the share capital of that class under such apportionment; (iiA) where any amount is under the provision of paragraph (i) of this proviso or that paragraphs as applied by paragraph (ii) of this proviso, deemed to be a profit available for distribution to shareholders and any of the shares of any class (hereinafter referred to as the original shares) held by any such shareholders are converted into shares of any other class or the original shares are cancelled and shares of any other class are issued in place of the original shares, the said amount shall, to the extent that it relates to or may have been apportioned to the original shares, be deemed to relate to and to be a profit available for distribution to the shareholders in respect of the shares of such other class and the provisions of this proviso shall, to the extent that the said amount is deemed to consist of a profit as aforesaid, apply in respect of such amount as though it were an amount referred to in paragraph (i) of this proviso, and the shareholders in respect of the shares of such other class shall, regardless of the rights attaching to such shares, be deemed as respects the said amount to be entitled to participate in profits of the same nature as the profit deemed by this paragraph to be available for distribution to the shareholders, whether such profit is of a capital nature or is not of a capital nature; Chapter 2 - A definition for dividends 17

(iiB) subject to the provision of paragraph (iiA) and (iv) of this proviso, where any amount is under the provision of paragraph (i) of this proviso or that paragraph as applied by paragraph (ii) of this proviso, deemed to be a profit available for distribution to shareholders and any shares issued by the company are cancelled without a return of the share capital or any share premium relating to such shares, such share capital or share premium or any reserve created by reason of the cancellation of such shares shall, to the extent that the said profit may be apportioned to the said shares, be deemed to consist of a profit (of the same nature as the aforesaid profit) available for distribution to shareholders who are or may become interested in such share capital, share premium reserve, and where any cash is or any assets are given to shareholders by way of a return of or a distribution out of such share capital, share premium or reserve, the sum of the amount of such cash and the value of such assets shall, to the extent that such sum does not exceed the amount deemed by this paragraph to consist of a profit available or distribution to shareholders, be deemed to be a profit (of the same nature as the firstmentioned profit) distributed to the

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 - (aa) to shareholders entitled to participate in distributions of profits which are not of a capital nature and in respect of whom any amount is deemed under

paragraph (i) (bb) of this proviso to be such a profit available for distribution to such shareholders, shall (to Chapter 2 - A definition for dividends 18

the extent that the amount returned to such shareholders does not exceed the aggregate of the amounts of the profits so deemed to be available for distribution to such shareholders) be deemed to be a profit, not of a capital nature, distributed to such shareholders, and the amounts so deemed to be available for distribution shall be deemed to have been reduced accordingly; or (bb) to shareholders entitled to participate in distributions of profits of a capital nature and in respect of whom any amount is deemed under paragraph (i) (aa) of this proviso to be such a profit available for distribution to such shareholders, shall (to the extent that the amount returned to such shareholders (less so much thereof as is deemed under subparagraph (aa) of this paragraph to be a profit, not of a capital nature, distributed to such shareholders) does not exceed the aggregate of the amounts of the profits deemed under the said

paragraph (i) (aa ► to be available for distribution to such shareholders) be deemed to be a profit of a capital nature distributed to such shareholders and the amount so available for distribution shall be deemed to have been reduced accordingly; (iv) where the company has lost some of its paid-up share capital (including any share premium) as a result of losses actually incurred by it and such share capital is in consequence partially reduced to take account of such losses, any amount which in terms of this proviso are at the date of such partial reduction of such share capital deemed to be profits available for distribution o shareholders shall be deemed to have been reduced to the extent that such losses are so accounted for and in such manner that, as far as possible and on the basis, where necessary, of an apportionment between different classes of share capital in accordance with the rights of Chapter 2 - A definition for dividends 19

shareholders - (aa) any such profits which are of a capital nature and relate to shareholders entitled to participate in profits of that nature, are reduced by so much of the amount by which the said share capital is reduced as is attributable to losses of a capital nature; and (bb) 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 amount by which the said capital is reduced as is attributable to losses which are not of a capital nature; (v) in the event of the winding-up or liquidation of a company - (aa) any profits which in terms of the preceding provisions of this proviso are, at the commencement of the winding-up or liquidation, deemed to be available for distribution to shareholders shall, if the company has lost some of its paid-up share capital (including any share premium) as a result of losses actually incurred by it, be deemed to have been reduced in such manner that, as far as possible and on the basis, where necessary, of an apportionment between different classes of share capital in accordance with the rights of shareholders, (A) any such profits which are of a capital nature and relate to shareholders entitled to participate in profits of that nature, are reduced by so much of the loss of the said share capital as is attributable to losses of a capital nature; Chapter 2 - A definition for dividends 20

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."

To summarise in short, for taxation purposes, dividends include the distribution of profits, whether in cash or otherwise, and whether of a capital nature or not. Exempted from the definition is, very importantly, capitalization shares in section (h) (ii). The consequences of this exemption is discussed in paragraph 7.4.8. of this thesis.

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.

2.3. A payment, allocation OT division 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).

Dividend payments, allocations or divisions relating to the different classes of shares_in issue at a company, may be categorised into various forms. The different forms are derived from the nature of the payments to be made. The following are some of the suggested forms of dividend payments (Van Dorsten, 1993:27): cash dividends (discussed in paragraph 6.4.); bonus dividends (discussed in paragraph 6.5.); dividends 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.).

Each of these forms of dividends can be paid to ordinary shareholders, preference shareholders, deferred shareholders or any other class of shareholders as an interim dividend, final dividend or liquidation dividend in some cases (Van Dorsten, 1993:27).

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. Sourced from rofit income or a fund

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.

2.4.2. ccounting definitions for profit, income or a fund

Accounting literature in South Africa and in other countries have attempted to define terms such as "income" and "profit".

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

of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. EXpenses are defined as the decreases in economic benefits during the accounting period of a company, in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (SAICA, 1990:par.70).

Paragraph .69 of AC 000 Framework for the preparation and presentation of financial statements, states that profit is frequently used as a measure of performance (SAICA, 1990). The elements directly related to the measurement of profit are income and expenses. Paragraph .73 of this document continues by stating that if a distinction is made between items of income and expenses, combining them in different ways would permit several measures of the performance of an organisation. Profit is, therefore, the net of income and expenses. Prior to the introduction of AC 103 Net profit or loss for the period, fundamental errors and changes in accounting policy, the terms profit and income were used interchangeably.

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" as the gross inflows of economic benefits during an accounting period, arising in the course of the ordinary activities of an enterprise when those inflows result in increases in equity, other than increases relating to contributions from equity participants (SAICA, 1994:par.09).

The Financial Accounting Standards Board, Statement of Financial Accounting

Concept No.6, Elements of Financial Statements, defines revenue as : "Revenues are the inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that Chapter 2 - A definition for dividends 25

constitute the entity's ongoing major or central operations" (Belkaoui, 1992:370).

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.

Income for an organisation would, therefore, be expected to be greater than revenue as it relates to the concept of "comprehensive income". The Financial Accounting Standards Board defines comprehensive income in Statement of Financial Accounting Concepts No 6, Elements of Financial Statements as: "...the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners" (Beresford, Johnson & Reither, 1996:69).

In defining comprehensive income, the American Financial Accounting Standards Board distinguishes revenues and expenses from gains and losses in Statement of Financial Accounting Concepts No. 6. Elements in Financial Statements. This statement refers to revenues and expenses as relating to the entity's ongoing major or central operations. Gains and losses are from peripheral or incidental transaction. AC 000 Framework for the preparation and presentation of financial statements discusses the issue in paragraphs .74 to .80 but concludes that gains and losses should not be treated differently for the purpose of the accounting framework (SAICA, 1 990). The importance of distinguishing items of income and expenses arising from the ordinary activities of the business from those that do not, is stressed in paragraph .72 of AC 000 Framework for the preparation and presentation of financial statements (Everingham & Hopkins, 1995:6-10,6-11).

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

A fund available for distribution among the shareholders of a company relates to equity. Equity is the residual interest in the assets of an enterprise after deducting all its liabilities (SAICA, 1990:par.49). The fund from which dividends can be paid, relates only to the distributable portion of equity.

Profit, rather than income or revenue or a fund should, therefore, be regarded as an amount from which dividends might be paid. "Income", however, needs further attention as it is an indicator of the performance of an enterprise and the primary focus of modern financial reporting (Hendriksen & Van Breda, 1 992:308).

2.4.3. The income concept

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).

Each of these views need further attention.

2.4.3.1. Synt cticai income

The syntactical approach to income is centred in accounting concepts such as realization, matching, the accrual basis and cost allocations that have a particular meaning for accountants and accounting students (Hendriksen & Van Breda, 1992:308 - 313). The "real world" can generally not be expected to understand or grasp the rules for the determination of syntactical income.

There are two approaches to measuring syntactical income, being the transactions approach and the activities approach. Chapter 2 - A definition for dividends 27

The transactions approach involves recording the changes in assets and liabilities as a result of external and internal transactions. The activities approach focuses on the description of the activities of the company. Income is assumed to arise when certain activities or events take place. The most important difference between the two approaches is that the transactions approach is based on the reporting process that measures an external event, being the transaction. The activity approach is based on the "real-world" concept of activities or events in a broader sense such as planning, purchasing and production.

Although syntactical income will be disclosed in the income statement of a company, it fails to reflect certain realities in the economic measurement of income because syntactical income is dependent on structural concepts that are difficult to explain to non-accountants who operate in the "real world".

2.4.3.2. Semanthcall income

Sematical income attempts to give net income economic content. Semantical income attempts to adjust accounting or syntactical income with economic depreciation rather than accounting depreciation (Hendriksen & Van Breda, 1992:314-318). Semantical income and syntactical income will, therefore, differ as economists and accountants use different methods of depreciation in presenting and reporting on income. Accountants use straightline or accelerated depreciation methods. Economists use the interest method. The efficiency of an organisation is thereby measured by potential investors based on economic measures. The results of these analyses and reanalyses are revealed in the fluctuations of a company's share price. The calculation of income will be based on economic information that is available, the perception of such information or the lack of perfect information. As one can never consider all economic realities in the calculation of economic or semantical income, net income cannot be defined to the agreement of all users. Analysts can agree on how income is calculated but not what it actually means and what impact income would have on the share price of Chapter 2 - A definition for dividends 28

a company.

2.4.3.3. Pragmatic income

Pragmatic income relates to the decision process of investors, creditors and others that are concerned with assessing the prospects for an enterprise's net cash inflows, the reaction of share prices to income reporting, the capital expenditure decisions of management and the feedback reactions of management and accountants (Hendriksen & Van Breda, 1992:319-323). Users of pragmatic income look towards the future inflows into an organisation based on reported income, irrespective of the way in which income is reported and how income is calculated.

2.4.3.4. Conclusion

Irrespective of the concept of income used, accounting income remains the basis for the different income views. Accounting income or syntactical income can generally be regarded as that which will be included in the income statement of an organisation. The income statement is generally considered as the starting point in deciding whether an organisation will be able to declare and pay dividends. Income and/or revenues in the income statement can, however, not stand alone as the quantum of expenses for a period has to be deducted from it. The resultant profit, is the basis that should be considered in determining legally divisible profit.

2.4.4. Legally divisible profit

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.

Profit, as defined by generally accepted accounting practice is now used by

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

COMPANY NET PROFIT FOR REFERRED TO AS YEAR END THE YEAR IN R'000

0 Dimension Data group (The 50 971 Earnings attributable 30/9/1995 Dimension Data group, to shareholders

1995:24)

0 Foschini Limited group 358 219 Retained income for 31/3/1995

(Foschini annual reports, the year 1995:30)

o Usko Limited (Usko Limited, 4 832 Retained income for 30/9/1993

1993:9) the year

The Courts have, over time, developed the term "profit available for dividends" as a legal concept, as opposed to the accounting concept of distributable profit in determining the amount that is available for payment to shareholders in the form of dividends. The calculation of "profit available for dividends" was devised and is regulated by common law rules relating to the maintenance of capital and other principles set in the course of various Court cases. Most of these Court cases were heard in England in the period 1860 to 1920.

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.

2.5. Made to shat eh Io °dere

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.

2.6. Authorised by the board of directors

2.6.1. Directors' Dna° rights and obligations

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

reserve that will be used at their discretion and

the directors may without placing, carry forward any profits that they may

prudently think not to divide (South Africa, 1 973).

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

formality to perform in authorising the payment of dividends. It is a matter of voting

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

be investigated thoroughly in each case.

The rules pertaining to the calculation and authorization of dividends show a clear

distinction and separation between the shareholders as owners of a company and

the directors who effectively govern the company in materially all respects including

the payment of dividends. Problems pertaining to corporate governance go back as

far as the separation of the ownership of a company from the control of the

business of a company. The difficulties associated with the stewardship duties of

directors (entrusting an agent with management of another's assets) are issues of

long-standing conflict between shareholders and directors (Keasey & Wright,

1993:291).

2.6.2. The stewardship duties of directors

The men and women who have been appointed to the board of directors' of

companies need to commit themselves in all respects to these companies. This

commitment holds onerous obligations that may be categorised under three

headings being:

a duty of loyalty;

duty of care and skill and duty of attention (Deloitte & Touche, 1995:13-1 7). Chapter 2 - A definition for dividends 33

2.6.2.1. Duty of loyalty

The first duty of loyalty places the obligation on directors that they should

not use their position as directors for personal gain.

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

the company (Cilliers, Benade, Henning, Du Plessis & Delport, 1992:137- 142).

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

discretion unhindered and (Cilliers et al., 1992:140-141). If a profitable

opportunity exists and it is within the scope of a company's activities and

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

treat all the information of the company in a confidential manner if the

information can affect the price of the company's shares or debentures (Deloitte & Touche, 1995:13). This particular duty is supported by section Chapter 2 - A definition for dividends 34

440 F of the Act which is a prohibition against insider trading (South Africa,

1973).

2.6.2.2. Duty of care and skill

The duty of care and skill requires of a director to: exercise his business judgement in good faith; make informed decisions based on all the relevant facts; take rational decisions and ensure there is no self-interest in decisions that he has made (Deloitte & Touche, 1995:14).

A director should ensure that he uses all his powers in good faith for the benefit of the company.

2.6.2.3. Duty of attention

The duty of attention requires of a director to attend all the meetings of a company, review all the available information at the company in order to make informed decisions, review board documentation and other distributed material and monitor the activities delegated to him. The activities that have been delegated to a director are normally detailed in the articles of

association of a company.

2.6.3. Management clause in the articles of association

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

these articles, required to be exercised by the company in general meeting,

subject to these articles, to the provision of the Act, and to such

regulations, not inconsistent with the aforesaid articles or provisions, -as may

be prescribed by the company in general meeting, but no regulation

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

made" (South Africa, 1973).

The inclusion of such a management clause in the articles of association of a

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

treasury management functions in an organisation.

2.6.4. Financial and treasury management

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

to shareholders reduces the amount of cash available for reinvestment. Conversely,

making use of alternative non-cash dividend payments, such as capitalization

issues, would preserve cash in the organisation that would become available for

reinvestment. An optimal dividend policy is one which would strike a balance

between current dividends and current growth in order to maximise the

organisation's share price (Collier, Cooke & Glynn, 1988:3). As dividend policy and

payments are described in management literature as financial and treasury

management, the involvement of management in dividend decisions carry greater

weight.

A company's dividend policy is a key area that is analysed when reviewing the

quality of financial management of an organisation (Ellis & Williams, 1993:296). A

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,

1993: 267). Refer to Table 2.2.

The success or failure of the management functions performed by the directors

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

BULLISH KEY DRIVER BEARISH

The competitive positioning Dividend prospects. Company's trading prospects

of the company in its chosen are deteriorating and the

markets, allied with good share price is currently an

operational management, is over-valuation of expected

likely to deliver an improving future performance and

dividend stream. dividend payments.

2.6.5. Fiduciary duties of directors

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 all, to maximise a company's current market value resulting in the creation of

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

towards the South African Reconstruction and Development Program.

The fiduciary duties of directors carry a heavy responsibility in overseeing the

business of the company.

2.6.6. Responsibilities of directors

The responsibilities of directors are addressed in chapter 5, section 2 of the King

Report on Corporate Governance. This Code details a number of guidelines in this

regard which would apply equally to executive and non-executive directors that are

as follows: directors should ensure that they have the time to devote to carry out

properly their duties and responsibilities to the company;

directors should be informed about the financial, social and political milieu

in which the company operates; directors must be satisfied that they are in a position to make informed

decisions; directors must never permit conflict of duties and interest;

directors must disclose potential conflicts of interest at the earliest

opportunity; directors must act independently of any outside fetter or instruction;

directors must act with enterprise and always strive to increase

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

substance over form being their guideline; directors must exercise the utmost good faith, honesty and integrity in all Chapter 2 - A definition for dividends 38

their dealings with or on behalf of the company;

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 collectively agreed by the board;

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;

confidential matters of the company, learned in their capacity as a director,

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

which the company's performance can be monitored;

directors must ensure that procedures and systems are in place to act as

checks and balances on the information being received- by the board;

directors must ensure that the board monitors the performance of executive

management against budgets, business plans, industry norms, prior year's

performance, etc.;

directors must ensure that the company has an affirmative action plan in

place to advance members of disadvantaged communities in the business of

the company as in most cases it will be necessary for the long term survival

of the company (The King Report on Corporate Governance, 1 994:22-25).

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

on a number of underlying concepts being:

that the company is a legal entity that is separate from the owners;

the power to govern the company is derived from ownership;

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

regularly to the shareholders on the stewardship of their investment; and

independent auditors appointed by the members report on whether the

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

shareholders could lead to a conflict of interest or a perceived conflict of interest

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

shareholders. This goal may be achieved through linking the compensation of

directors to performance and implementing audit committees (Keasy & Wright,

1 993:296,300).Until such time as the principles of corporate governance is applied

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

Suppliers Customer Providers of Employees

non-equity

finance Chapter 2 - A definition for dividends 40

2.6.7. Shareholders' rights v directors' prerogative

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

of the company. The answer is, unfortunately not as straightforward as the

question.

If the shareholders of a company are given the right to calculate and declare

dividends by virtue of the stipulations of the articles of association, there is no

question that they will have that right.

If line 84 to 90 of Table A, or line 83 to 89 of Table B of Schedule 1 of the Act

(South Africa, 1973), or similar lines, were adopted by a company (refer to

paragraph 2.6.1.), or if there were no similar stipulations in the articles of

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.

In the case of In re a Company (no 00370 of 19871, Ex parte Glossop [1988] 1

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

would be risky and problematic.

In the British case of Hood-Barrs v Commissioners of Inland Revenue [1946) 2 All ER 768 (CA) at 775, Lord Greene MR had a clearer opinion. In discussing the rights

of a shareholder, he said (Van Dorsten, 1 993:26): "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.

Strategic management has five interrelated components, being: developing a concept of the business and forming a vision of where the organisation should be headed to, establishing a mission for the organisation; translating the stated mission of the organisation into long term and short term objectives; crafting a strategy to achieve the stated objectives; implementing the strategy and evaluating performance, reviewing the situation and initiating corrective action if needed (Thompson & Strickland, 1990:4).

The application of the principles in the King Report on Corporate Governance (Coopers & Lybrand, 1 995) as well as the age-old principles of the fiduciary and custodian responsibilities of directors should safeguard not only the shareholders but also all the other stakeholders of a company against decisions, strategic or otherwise, that would intentionally prejudice them.

If the decision on the payment of dividends is left to the shareholders, a degree of subjectivity could cloud their view. The purpose of investing in the shares of a

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. In principle there is nothing wrong with these different emphases or

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)

624-625 stating, that there is no duty on shareholders when they meet as

shareholders to act in the interest of the company. The shareholders do not act as

agents. He further said that:

'...[I]t also gives a general right to the company to distribute its assets to

shareholders. This offends against certain principles of company law basic

to the concept of limited liability as introduced by Parliament - at any rate

in regard to companies limited by shares, as this one was, namely:

The company is a separate legal persona, owning the assets.

The directors manage the affairs of the company in a fiduciary

capacity to it.

The shareholders' general right of participation in the assets of the

company is deferred until winding-up, and then only subject to the claims of creditors.

Neither shareholders nor directors nor the company itself can violate the foregoing, whatever the memorandum or articles may say."

Regarding the subjective need of an individual investor to receive dividends and possibly despoil the company, Centilivres, CJ said in Rex v Milne and Erleigh (7)

1951 (1) SA (AD) 791 (AD) at 817 F, that it is hard to imagine that any person of ordinary intelligence would believe that he had the power to despoil or rob the company in relation to which he stands in a fiduciary capacity.

2.6. Shareholder rights movements in Europe

In general directors and managers on the European continent have been so Chapter 2 - A definition for dividends 43

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

There appears to be no clear answers to the question whether the shareholders or

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

emphatic on this matter.

Hopefully sanity will prevail so that directors will be given this responsibility.

The payment of dividends should be considered as part of the strategic

decisionmaking process of a company. This is surely the responsibility of the

directors of a company. In this, the needs of all stakeholders, not only the shareholders, should be taken into account, as the directors have an ultimate responsibility to the company and to a lesser extent the environment in which the

company operates. The King Report on Corporate Governance states that these

stakeholders include employees, bankers, suppliers, customers, environmentalists,

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

of the shareholder group. These individual needs should, however, be considered

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

shareholders after being authorised by the board of directors of a company.

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 be performed solely by the directors as stewards of the company whose responsibility it should be to decide what, if any, amount should be declared to shareholders as dividends.

Consideration should be given to the nature or form of dividends that are to be paid once the maximum distributable amount available is calculated.

The rules relating to the calculation of profit legally available for distribution as dividends will be discussed in detail in chapter 3 of this thesis. Chapter 2 - A definition for dividends 45

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KEASEY, K & WRIGHT, M 1 993: Issues in Corporate Accountability and Governance: An Editorial. Accounting and Business Research, Volume 23 Number 91A Corporate Governance Special Issue 1993: 291-303.

KPMG 1 995: Toolkit for the Company Director. Johannesburg: KPMG.

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 DIMENSION DATA GROUP 1995: Annual report 1995.

THE INVESTORS' GUIDE 1996: Issue 77. The Johannesburg Stock Exchange. Johannesburg: The Investors' Group (Pty) Ltd.

THE KING REPORT ON CORPORATE GOVERNANCE 1994. Johannesburg: The Institute of Chapter 2 - A definition for dividends 47

Directors in South Africa.

THE SOUTH AFRICAN BREWERIES LIMITED 1996: Annual report 101st year ending 31 March 1996.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1990: AC 000 Framework for the preparation and presentation of financial statements. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1992: AC 104 Earnings and dividends per share. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1994: AC 111 Revenue. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1995: AC 103 Net profit or loss for the period, fundamental errors and changes in accounting policies. Johannesburg: SAICA.

THOMPSON, AA & STRICKLAND, AJ 1990: Strategic Management Concepts and Cases; fifth edition. BPI Irwin: Boston.

USKO LIMITED 1 993: Annual report. September 1993.

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.

VERKLARENDE HANDWOORDEBOEK VAN DIE AFRIKAANSE TAAL 1988: tweede uitgawe; sewende druk. Johannesburg: Perskor-Uitgewery. Chapter 3 - Profit available for distribution as dividends 48

CHAPTER 3 - PROFIT AVAILABLE FOR DISTRIBUTION AS DIVIDENDS

"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

embarrassment of business men in the conduct of business affairs."

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.

3.2. Principles applied in Court cases on dividend matters

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

December 1976, which provides in section 15(1) that:

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

previous years (Van Dorsten, 1993:62).

Although similar legislation does not exist in South Africa, the capital maintenance principle is consistently applied in studying South African accounting issues of which dividends is one.

3.3. The principle of capital maintenance

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 preparation and presentation of financial statements (SAICA, 1990:par.105):

"The concept of capital maintenance is concerned with how an enterprise defines

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

which profit is measured; it is a prerequisite for distinguishing between an

enterprise's return on capital and its return of capital; only inflows of assets in

excess of amounts needed to maintain capital may be regarded as profit and

therefore as a return on capital. Hence, profit is the residual amount that remains

after expenses (including capital maintenance adjustments, where appropriate) have

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 maintenance (SAICA, 1990:par.103).

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 or profit can, therefore, be measured in nominal monetary units or units of constant purchasing power. Increases in the prices of assets held over a period would conceptually be holding gains or profits if the increases in general price levels are taken into account

(SAICA, 1990:par.104,.107).Financial capital maintenance is one of the conceptual pillars 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 of equity and not profit (SAICA, 1 990:par.1 04,.1 09).

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 trading or conducting business when profit is measured in units of constant purchasing 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 profit that may be legally distributed as dividends.

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 dividends are locally used for this purpose.

3.4. Common law rules

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 of dividends (Cilliers, Benade, Henning, Du Plessis & Delport, 1992:314,315,344-357).:

Rule Rule: number:

1. Dividends may not be paid out of the paid up share capital of a company as

contributed by the members (discussed in paragraph 3.5.). Chapter 3 - Profit available for distribution as dividends 52

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.).

Losses on circulating or working capital should be taken into account in the calculation of profit available for legal distribution (discussed in paragraph 3.8.).

Realised profits on the sale of fixed assets may be distributed as a dividend (discussed in paragraph 3.9.).

Unrealised profits or gains on the revaluation of circulating or working capital may be distributed as a dividend (discussed in paragraph 3.10.).

Unrealised profits on the revaluation of fixed or permanent assets may be distributed as a dividend in some cases (discussed in paragraph 3.1 1 .1.

The financial position of a company as a whole as reflected in it's audited financial statements should be considered when profit available for legal

distribution is calculated (discussed in paragraph 3.1 2).

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 and the decisions taken by it (Kieso & Weygandt, 1986:660).

Each of the common law dividend rules will be discussed below. Chapter 3 - Profit available for distribution as dividends 53

3.5. Rule 1 - Dividends may not be paid out of share capital

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

current levels sounds similar to the complicated accounting theory of capital maintenance.

3.5.2. Capital maintenance

The capital maintenance theory implies that income should only be recognized after

capital has been maintained or costs have been recovered (Belkaoui,

1992:271,272). The two principal concepts encompassed by this theory, may be categorised as financial capital maintenance and physical capital maintenance. Both 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

Courts' view of the sophisticated accounting theory of capital maintenance (Cilliers

et al., 1992:347).

3.5.3. South African case law

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

with this amount. They proceeded to distribute the proceeds by declaration of

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

laid down the following principles: a shareholder is not entitled to his share of the profit of a company unless

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

which they are to be paid; capital may be lost or spent in the ordinary course of business, but it cannot

be reduced except in the manner described by the Companies Act; a dividend cannot be declared which has the effect of diverting a portion of Chapter 3 - Profit available for distribution as dividends 55

the corpus of the company to the shareholders and any ultra vires application of the company's money is in fact a breach of trust on the part of the directors of a company, yet again highlighting the responsibility of the directors for the safeguarding and custody of the assets of the company.

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.

3.5.4. Exceptions to the capital maintenance principle

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

or issue of any shares of the company.

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

enterprise's return on capital and its return of capital (SAICA, 1990:par.105).

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 earned on capital The return on capital employed ratio is one of the most frequently referred to

Chapter 3 - Profit available for distribution as dividends 57

statistics in measuring the strengths and weaknesses of an organisation (Collier, Cooke & Glynn, 1988:54). The ratio reads as follows (Bringham & Gapenski, 1988:779):

Return on capital = Net income available to ordinary shareholders Ordinary share capital

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

RETURN ON CAPITAL EMPLOYED = INCOME AVAILABLE AVERAGE CAPITAL EMPLOYED

NET PROFIT MARGIN ASSET TURNOVER =INCOME AVAILABLE TURNOVER TURNOVER AVERAGE CAPITAL EMPLOYED

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. Rule 2 - Accumulated losses suffered in past trading periods may be ignored

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.

The benchmark case in respect of this rule is Ammonia Soda Co v Chamberlain

[191811 Ch 266 (Cilliers et al., 1992:351). Swinfen Eady LJ said at 283: "The Companies Acts do not impose any obligation upon a limited company, nor does the law require, that it shall not distribute as a dividend the clear net profit of its trading unless its paid-up capital is intact or until it has made 'good all losses incurred in previous years" (Van Dorsten, 1 993:69).

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.

3.6.2. The nature of accumul ted 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

1990:par.47). Accumulated losses consequently has to fit into one of these categories.

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.

Liabilities are categorised as legally enforceable obligations (SAICA, 1 990:par.60). Accumulated losses cannot conceivably be categorised as such, as no outflow would result from it. If an investor chooses to sell his shares based on the accumulated losses of a company, there is merely a change in the name of a shareholder in the company's register of members. The paid-up share capital that he has contributed cannot be repaid to him by the company as such a step will Constitute an illegal capital reduction.

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

Cash or scrip dividends Adjustments due to quasi reorganisation

Stock and property dividends

Some other share transactions

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.

3.6.3. Effect of ace mulated losses on the capital fund of a com any

As discussed in paragraph 3.6.2., accumulated losses form part of the equity of a company. The concept of equity is synonymous with the net assets or capital of a company for purposes of the capital maintenance theory (SAICA, 1990:par.102). Capital, for this purpose, is a wider concept than that of the issued share capital of

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).

A company returning accumulated losses on its activities would experience a Chapter 3 - Profit available for distribution as dividends 61

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.

3.6.4. Accumulated losses v retained earnings

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

side being accumulated losses. An accumulated loss is regarded by the Courts as

a non-entity.

If this status of a non-entity is given to accumulated losses it would provide for a

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

had a bearing on their decision. .

3.6.5. Dividing results into trading periods

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.

3.6.6. The advantage to an investor

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).

Refer to Table 3.3.:

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

1992: ( R 159 703k) R 6 674k Preference dividend ( R. 6 587k)

Retained earnings for the year R 87k

1993: ( R 159 616k) R 19 854k Preference dividend ( R 15 048k)

Retained earnings for the year R 4 806k

1994: ( R 154 810k)

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

taken into account in maintaining the capital fund of a company. Chapter 3 - Profit available for distribution as dividends 64

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. Rule 3 - Provision for losses on fixed capital and depreciation of fixed capital may be ignored

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

[1918] 1 Ch 226 (CA). Scrutton LJ concluded as follows: "[T]here was in this case no obligation on the plaintiff company, before Chapter 3 - Profit available for distribution as dividends 65

paying dividends out of profits accrued in an ordinary period of its working, to make good losses of capital which had accrued in a previous ordinary working period" (Van Dorsten, 1 993:70).

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..

3.7.2. The nature of fixed capital

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 Ammonia Soda Company Limited v Chamberlain El 91 81 1 Ch 266 (CA), Swinfen Eady LJ put forward the following points in discussing the meaning of fixed capital: it is the shape of assets upon which subscribed capital is expended; these assets either produce their own income independent of further intervention by the company or is used by the company to produce income; it is invested in assets intended to be retained by the company more or less permanently and it may be used up (Van Dorsten, 1 993:70) .

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

Fixed capital referred to by the Courts would, therefore, generally be referred to by accountants as fixed assets and classified as such in the balance sheets • of companies based on the judges' points. Generally these assets would carry a 'depreciation charge that would create an accounting reserve in the form of accumulated depreciation. The third dividend rule in other words, relates to depreciation and losses on fixed assets which may be ignored in the calculation of profit available for distribution as dividends. With fixed assets being referred to as fixed capital by the Courts, it leaves the term "losses" to be considered.

3.7.3. The nature of losses

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

judged that depreciation on plant and machinery should be ignored in determining profit available for distribution as dividends.

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.

3.7.4. The nature of depreciation

The accountant can view depreciation in one of three ways: it can be seen as a cost allocation (discussed in paragraph 3.7.4.1.); as a means of valuing assets (discussed in paragraph 3.7.4.2.) or as a means of reserving funds for the replacement of assets (discussed in paragraph 3.7.4.3.) (Dempsey, 1988:14).

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.

3.7.4.1. Depreciation as a cost allocation

In adopting this view, depreciation is seen as an allocation of the cost of a fixed asset. The cost of the asset is regarded as a prepaid expense. This prepaid expense is allocated or written off over a number of future periods in which the company will receive a benefit from the asset. Depreciation is regarded as an expense similar to any other expenses such as labour costs, electricity costs, prepaid insurance etc. If depreciation is ignored or if the allocation per period is too high or too low, the profit of the company will not be correct (Dempsey, 1988:9).

If one relates this theory on depreciation to the four fundamental accounting Chapter 3 - Profit available for distribution as dividends 68

concepts of matching, prudence, going concern and consistency (SAICA, 1 974:par.03), the matching concept dictates that this view of depreciation

has to be sound.

The classification of depreciation as a cost allocation is supported by two South African accounting standards. AC 123 Property, plant and equipment

states that the depreciation charge for a period is usually recognised as an

expense (SAICA, 1994a:par.44-.52). Further, the depreciable amount of an

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

in which the asset's economic benefits are consumed by the company. AC 123 Property, plant and equipment applies to all property, plant and

equipment (SAICA, 1 994a:par.03).

AC 106 Depreciation Accounting is currently only applicable to investment

property (SAICA, 1982:par.01). Paragraph .10 of AC 106 Depreciation

Accounting states that depreciation is a measure of the extent to which

fixed assets have been worn out, consumed or lost its value, whether arising

from use, effluxion of time or obsolescence through technological and

market changes (SAICA, 1982). Depreciation is allocated to different

accounting periods on bases calculated to charge a fair proportion of the cost of an asset to each accounting period during the expected useful life

of that asset.

The South African standards used to define depreciation is in line with International Accounting Standard 16 (revised) Property, Plant and

Equipment which concurs that depreciation is the systematic allocation of a depreciable amount of an asset over its useful life (Everingham & Hopkins, 1995:174).

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

Courts paid no heed to the conceptual, accounting theory relating to the nature of depreciation in defining the third common law dividend rule.

3.7.4.2. Depredation as a means of revaluing assets

Viewing depreciation as a means of revaluing assets are frequently seen by the public as a means of placing a fair value on the fixed assets of a company. The purpose of depreciation is therefore to determine the value of an asset. As soon as the value of an asset is determined, depreciation is a side-issue (Dempsey, 1988:11).

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.

Paragraph .45 of AC 123 Property, plant and equipment states that a depreciation charge has to be made even if the value of an asset exceeds its carrying amount (SAICA, 1994a).

AC 106 Depreciation Accounting (SAICA, 1982:par.09) backs up the fact that this view of depreciation is incorrect by saying that the net amount at which the investment property of a company are carried in the financial statements does not necessarily profess to be their realisable value.

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.

3.7.4.3. Depreciation as a means of reserving funds for the replacement of assets

Viewing depreciation as a means of reserving funds for the replacement of Chapter 3 - Profit available for distribution as dividends 70

assets, relates to one leg of the capital maintenance theory referred to in paragraph 3.3., being the concept of physical capital maintenance. In general, depreciation cannot reserve sufficient funds for the replacement of assets because it does not generate cash and does not take inflation into account (Dempsey, 1988:13-14).

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

Dempsey (1 988:14) concluded in 1988 that the view of depreciation which was conceptually sound, if the matching concept is taken as the point of departure, is that depreciation is a process of allocating the cost of fixed assets over the productive life of the assets.

The release of AC106 Depreciation Accounting (SAICA, 1 988) later that year also concluded conceptually that depreciation is the allocation of the cost of a fixed asset over its useful life.

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).

Depreciation further satisfies the requirements of the definitions of an expense in terms of AC 000 Framework for the preparation and presentation

of financial statements as discussed in paragraph 2.4.2. Chapter 3 - Profit available for distribution as dividends 71

Based on the principles laid down in the above mentioned literature, the

Courts were surely mistaken in its view to ignore depreciation in the

calculation of profit available for dividends. Depreciation is regarded by

accountants as simply another expense of the company. No distinction is

made between depreciation and other expenses and there is, therefore, no

reason why depreciation should be ignored and other expenses taken into

account in calculating profit available for distribution as dividends.

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

capital, debtors, expenses and other items in the financial statements of a company.

3.7.5. The ruie in perspective

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

have a look at the audited financial statements of a number of companies. Refer to

Table 3.4.

TABLE 3.4 DEPRECIATION V DIVIDENDS

COMPANY YEAR TOTAL TOTAL DIVIDEND END DEPRECIATION CHARGE PER PER INCOME INCOME STATEMENT STATEMENT

8 Dimension Data group (The Dimension 30/9/94 R 2 085k R 43k Data group, 1995:24,30)

8 The South African Breweries Limited 31/3/95 R 930million R 645million Group (The South African Breweries Limited, 1995:53,68)

o Conshu Holdings Limited Group 31/3/95 R 13 501k R 13 565k (Conshu Holdings Limited, 1995:19,27) Chapter 3 - Profit available for distribution as dividends 72

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

Based on the conceptual view of the nature of depreciation, it can be concluded that the most accurate way of looking at depreciation is as an allocation of the cost of a fixed asset over time, just as any other expense is allocated over a particular period. In accounting theory there is no difference between depreciation and other allocated expenses. It should, therefore, be treated in the same way as all other expenses.

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.

3.8. Rule 4 - Losses on circulating OT working capital should be taken into account

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) where Swinfen Eady LJ said: "What is circulating capital? It is a portion of the subscribed capital of the company intended to be used by being temporarily parted with and circulated in business, in the form of money, goods or other assets, and which, or the proceeds of which, are intended to return to the company with an increment, and are intended to be used again and again, and to always return with some accretion.

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

reflect this fact in the profit for the year.

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.

3.9. Rule 5 - Realised profits on the sale of fined assets may be distributed

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 term "realised" explains it all.

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.

The American Financial Accounting Standards Board defines "realization" as: "...the process of converting (non-cash] resources and rights into money"

(.Hendriksen & Van Breda, 1992:361).

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 reasonable certainty (SAICA, 1 974:par.07).

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, nor accountants can protest at its inclusion and application.

3.10. Rule 6 - Unrealised profits on the revaluation of circulating or working capital may be distributed

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 discussed in paragraph 3.8.

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 normal operating cycle of a business as discussed in paragraph 3.8. Generally speaking, 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

laid down in section 79.

The requirements of section 79 of the Act (South Africa, 1 973) are as follows:

the payment should be authorised by the articles of association or by special

resolution and

approval should first be obtained from the Minister 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

the rate that may be determined by the Minister.

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 following criteria have been met:

the significant risks and rewards of ownership of the goods have been transferred

by the company to the buyer;

the company retains neither continuing managerial involvement to the degree

usually associated with ownership nor effective control over the goods sold;

the amount of the revenue can be measured reliably;

when it is probable that the economic benefits associated with the transaction will

flow to the company and

the costs incurred or to be incurred in respect of the transaction can be measured

reliably.

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. Rule 7 - Unrealised profits on the revaluation of fixed assets may be distributed

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.

The benchmark Dimbula Valley-case was followed by similar findings in a New Zealand case in Re New Zealand Flock and Textiles Ltd [1 976] 1 NZLR 192 (Cilliers

et al., 1992:352).

There is no specific South African legislation regarding this issue, neither do we have a local court case that considered the matter (Van Dorsten, 1993:75). From a legal perspective, this common law rule will remain entrenched in South Africa in the mean time. The debate on the application of the rule will continue as not all legal experts are in agreement with the principles of the rule. Chapter 3 - Profit available for distribution as dividends 78

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 v Inland Revenue Commissioners [19601 TR 105-109 stated that in their views, at the time of a revaluation there is neither a realised nor an immediate realisation to revaluation profits, nor can it be distributed until it is realised (Van Dorten, 1993:75).

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

3.11.3. Accounting recognition of the common law rule

Guideline AC 202 Accounting for fixed asset revaluations (SAICA, 1983:par.18)

acknowledges that there is a legal precedent permitting the distribution to shareholders of a revaluation surplus via a dividend. The guideline, however,

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

distribution of the revaluation surplus as dividends is not clearly prohibited in either

AC 202 Accounting for fixed asset revaluations (SAICA, 1983) or AC 123

Property, plant and equipment (SAICA, 1 994a) as being illegal.

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:

"the aggregate amount of the dividends paid or proposed, and if such

dividends are provided partly or wholly from capital profits, a statement to

that effect".

3.111.4. Accounting guidelines for fixed asset revaluations

The South African Institute of Chartered Accountants issued a guideline AC 202

Accounting for fixed asset revaluations in 1983 (SAICA, 1 983). The guideline does

not attempt to consider the merits of the objectives behind the dedision to adopt a policy for the revaluation of fixed assets. The guideline does, however, state that management should consider the following in the application of fixed asset revaluations (SAICA, 1983:par.03): productive and monetary capital maintenance; retention of earnings; balance sheet value of fixed assets and the amount of depreciation.

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

statements prepared in accordance with the historical cost convention in times of changing prices. Management teams who revalue fixed assets during an accounting period should consider the disclosure of the objectives of the revaluation (SAICA, 1 983:par.04-.1 8). The disclosure of the revaluation of fixed assets is dealt with in paragraph 22 of Schedule 4 of the Act (South Africa, 1 973). According to the Act, the following information should be disclosed as regards fixed assets, the amount of which was arrived at by reference to a valuation: the most recent year in which the assets were severally valued; in the case of assets valued in the current year, the names and qualifications of the persons who valued them; the basis of valuation and the policy regarding the frequency of valuation.

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).

In general, surpluses arising from revaluations should be credited directly to a non- distributable reserve account (SAICA, 1983:par.24).

A more recent introduction to South African Accounting Standards is AC 123

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

of the revaluation of fixed assets as follows: Paragraph .41 "When an asset's carrying amount is increased as a result of a revaluation, the increase should be credited Chapter 3 - Profit available for distribution as dividends 81

directly to equity under the heading of revaluation surplus. However, a revaluation increase should be recognised as income to the extent that it reverses a revaluation decrease of the same asset previously recognised as an expense."

Paragraph .42 "When an asset's carrying amount is decreased as a result of a revaluation the decrease should be recognised as a expense. However, a revaluation decrease should be charged directly against any related revaluation surplus to the extent that the decrease does not exceed the amount held in the revaluation surplus in respect of that same asset."

Paragraph .43 "The revaluation surplus included in equity may be transferred directly to retained earnings when the surplus is realised. The whole surplus may be realised on the retirement or disposal of the asset. However, some of the surplus may be realised as the asset is used by the enterprise being, the difference between depreciation based on the revalued carrying amount of the asset and depreciation based on the asset's original cost. The transfer from revaluation surplus to retained earnings is not made through the income

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

be utilised for distribution as dividends upon realisation. An unrealised revaluation surplus on fixed assets is after all neither at a company's disposal nor does it take on the form of cash (Wedgwood, 1995:113). Chapter 3 - Profit available for distribution as dividends 82

3.111.5. Realisation of surpluses on the revaluation of fixed assets

Guideline AC 202 Accounting for fixed asset revaluation (SAICA, 1983:par.16) states that surpluses or losses on the revaluation of fixed assets are only realised at the sale or scrapping of the said assets. A transfer from the surplus created at the time of the revaluation may be made directly to distributable reserves at the time of realisation, therefore allowing reserve accounting. AC 202 Accounting for fixed asset revaluations (SAICA, 1983) also allows three other specific uses for the surplus on revaluation.

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 is converted into money as discussed in paragraph 3.9. The distribution of the revaluation reserve prior to the sale or scrapping of an asset will, therefore, be conceptually incorrect.

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

based on the original cost of the asset (SAICA; 1994a:par.43).

Conceptually, the sound accounting option that companies may utilise if they wish Chapter 3 - Profit available for distribution as dividends 83

to declare unrealised revaluation surpluses, is to calculate the depreciation

difference to date between the depreciation on the revalued asset and the 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.

3.11.6. Legality of the application of the common law ruse

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. PvacticaSappSication of the rule

3.11.7.1. Intvoduction

The second question of Part 2 of the 1995 Qualifying Examination of the Chapter 3 - Profit available for distribution as dividends 84

Public Accountants and Auditors Board, sketch a scenario where a certain company made a transfer from a reserve it created at the time of the revaluation of its freehold estate, to its income statement in order to pay dividends to the shareholders of a company. A similar situation was found in the saga of the Masterbond group of companies that gripped the interest of many South Africans for a number of years.

3.11.7.2. A synopses of the history of the Masterbond group of companies

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

individual investors bearing the brunt (Gordon - Fish, n.d.:41 - 58). Chapter 3 - Profit available for distribution as dividends 85

At the time of its demise in 1991, the Masterbond group comprised 81 companies, it employed 205 people, operated 85 bank accounts, had a direct or indirect interest in about 50 property development companies and had collected R595million from 20 000 investors (Anon., 1 992:40).

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).

Many an investor was coerced into investing in the Masterbond group, based on the excellent bookvalue of the group's asset base which was revalued regularly.

3.11.7.3. Revalluation of the assets of the Masterbond group

As stated in paragraph 3.11.7.2. of this chapter, some of the companies in the Masterbond group had to increase capital internally by revaluing some of its properties based on inflated property valuations. These reserves were channelled to the income statement in order to pay interest and dividends to investors in the group.

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

later stage a dividend of R315 000 was declared to Masterbond Property Participation No 1 2-holders out of Methyr Properties' general reserve which had been boosted by the revaluation of the Pinetown property. The Nel commission hearing testimony on the Masterbond debacle heard evidence Chapter 3 - Profit available for distribution as dividends 86

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

revaluation of the property (West, 1994:3).

Relating to other dividend matters in the Masterbond group, the curators of

the Masterbond group are currently also taking steps against Mr. Andre

Pieterse, former chairman of Fancourt, for recovering R3 million that he paid

to himself and his family in the form of dividends when this company did not

make a profit (Anon., 1995:53).

3.1 1 .8. Conclusion

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

equipment and AC 202 Accounting for fixed asset revaluations.

The following are a number of facts that should be considered (Van Dorsten,

1993:77):

the distribution of the reserve created on the revaluation of fixed assets, is not prohibited in terms of the Companies Act; because annual financial statements must conform with generally accepted

accounting practice, it does not mean that dividends should be declared solely out of profit; profit available for distribution is not the same as accounting profit and

the Dimbula Valley case remains persuasive when considering the legality

of such a distribution.

Furthermore, no legislation currently exists to enforce the application of Generally Accepted Accounting Practice in preparing financial statements. This position

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. Rule 8 - The financial position of a company as a whole should be consideved

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

without reference to the result of the whole accounts fairly taken."

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.

3.12.2 Consequences if the wile is broken

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.

3.12.3. Effect of media disclosure of qualified audit opinions

An American study was conducted in 1988 to evaluate the "subject to" qualification of audited annual financial statements and its announcement in the Wall Street Journal, to determine the effect of such an announcement on share prices (Letourneau, 1988:5). Letourneau commented that several studies have shown that the release of financial statements to the general public has little effect

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

qualifications where there were an uncertainty acknowledged by the auditors, the Chapter 3 - Profit available for distribution as dividends 89

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).

One wonders whether a recent innovation by the Johannesburg Stock Exchange will have any effect on the public, given the American experience. This innovation is to make a press announcement and thereafter flag the names of quoted companies whose financial statements have been qualified by their auditors with a "0" in the popular press. Their proposed training and awareness scheme to empower small individual investors will need to take into account that non- accountants (and some would say accountants) do not understand the full impact of financial statements and the qualification thereof. This training and education program is one of the recommendations of the Katz-report on the future of the Johannesburg Stock Exchange (The Johannesburg Stock Exchange, 1994:359- 360).

3.12.4. Effect of qu °Hied audt • pktions on an auditov

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

(1991) (Krishnan, Krishnan & Stephens, 1996:225).

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

statements of companies (Krishnan et al., 1 996:225).

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

Securities and Exchange Commission as: "...the search for an auditor willing to support a proposed accounting treatment designed to help a company achieve its reporting objectives even though that treatment might frustrate reasonable reporting" (Krishnan et al., 1996:225).

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.

3.13. Status of the rues in England

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 section 39 are summarised in Table 3.5.

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 included in chapter 9 of this thesis. Chapter 3 - Profit available for distribution as dividends 91

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.

debentures or amounts payable on share capital. It may however be utilised for the payment of fully paid up bonus or Yes.

capitalization shares.

Accumulated losses from previous years will have to be made up No. before dividends are paid to the extent that it has not been written

off in terms of a scheme of reorganisation or reduction in capital.

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

curbed the use of the controversial common law dividend rules.

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 investor is, after all, receiving dividends on his investment. Chapter 3 - Profit available for distribution as dividends 92

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

whether the rules are defendable by accounting theory.

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 may incorrectly reflect different techniques in smoothing profits. The imperfections in 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.

The imperfections in financial statements will be considered in chapter 4 of this thesis. 0i Chap ter 3 - Profit available for dis tribu tion as dividends

1 SU MMARY - COM M ON LAW DI VI DEND RULES II Lu CI °- a 7.1 w a Q 0- II c:C CE n -J UJ D —1 Lid CC 0 z 4: z — _ I*1 C •

i B Y CD Z w _1 < z 0 AC COU NTING >- a) cn v

. Div idends may not be p aid out of share capital. p ar. 3. 5. Yes Yes Z cYi 0 N ci. as Ac cu mu lated losses suffere d in p ast periods may be ig nore d. to Ye s No Z )- Z 0 o cvi Prov isions for losses in fixed assets and depre ciatio n on fixe d p ar. 3. 7. a) cn

assets may be ig nored. >- >- >- a) cn a) a) cn cn 4 Losses and dep reciatio n o n circu lating c ap ital s hould be ta ke n p ar. 3. 8.

into account.

tri Realised p ro fit o n the sa le of fixed a ssets may be distr ibuted. p ar. 3. 9. Yes Yes Yes II Z cvi c Z >.- 0 a) 6 a_ cis cn - Unre al ised p ro fit o n the re valu atio n o f c irc ulating cap ita l may .5

be distributed. Z Z cfi ).- , 0 o a) cn a_ ce IN Unrea lise d pro fit on the revaluatio n of fix ed asse ts may be

distr ibuted. >- >- >.- Ni c6 a) cn a) Cl) a) to 03 a_ 00 The fin ancia l po sit ion o f a co mp any as a w ho le should be _ co nside re d. 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.

CONSHU HOLDINGS LIMITED 1 995: Annual report 1995.

CORREIA, C; FLYNN, D; ULIANA, E & WORMALD, M 1989: Financial management; second edition. Cape Town: Juta & Co, Ltd.

DEMPSEY, A 1988: Verantwoording vir waardevermindering in die finansiele state van maatskappye. Johannesburg: Randse Afrikaanse Universiteit (M.Com .-skripsie).

EVERINGHAM, G & HOPKINS, B 1995: Generally Accepted Accounting Practice (as amended). Cape Town: Juta & Co, Ltd.

GILIOMEE, A 1996: Company law set for radical transformation. Business Day, July 12 1996: 1.

GORDON-FISH, Z n.d.: Mickey Mouse and other stories. Millennium, n.d.:41-58. Chapter 3 - Profit available for distribution as dividends 95

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.

KRISHNAN, J; KRISHNAN, J & STEPHENS, RG 1 996: The Simultaneous Relation Between Auditor Switching and Audit Opinion. Accounting and Business Research, Volume 26 Number 3: 224-236.

LETOURNEAU, DE 1988: Evidence on whether media disclosure of "subject to" audit opinions affects stock prices. Louisiana: College of administration and business Louisiana Tech University (D.B.Admin. dissertation).

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 DIMENSION DATA GROUP 1995: Annual report 1995.

THE JOHANNESBURG STOCK EXCHANGE 1 994: Report of the research sub-committee on the future structure of the Johannesburg Stock Exchange to the Johannesburg Stock Exchange Committee. Johannesburg: The Johannesburg Stock Exchange.

THE SOUTH AFRICAN BREWERIES LIMITED 1995: Centenary annual report. March 1995.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1974: AC 101 Disclosure of accounting policies. Johannesburg: SAICA. Chapter 3 - Profit available for distribution as dividends 96

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1982: AC 106 Depreciation Accounting. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1983: AC 202 Accounting for fixed asset revaluations. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1990: AC 000 Framework for the preparation and presentation of financial statements. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1994a: AC 123 Property, plant and equipment. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1994b: AC 111 Revenue. Johannesburg: SAICA.

USKO LIMITED 1 993: Annual report. September 1993.

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 1 994: Masterprop 'dodged taxes'. Business Day, February 23 1 994: 3.

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

CHAPTER 4 - IMPERFECTIONS IN FINANCIAL STATEMENTS

"One of the benefits of inflation is that kids can no longer get sick on a nickel's

worth of candy." - Journeyman Barber magazine (Peter, 1977:338).

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 statements (SAICA, 1990:par.12).

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 the accounts, balances or values embodied in financial statements should be considered 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.

4.2. Accounts, balances or values referred to by the common law dividend rules

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 rules are summarised in Table 4.1. Chapter 4 - Imperfections in financial statements 99

TABLE 4.1.

ACCOUNTS, BALANCES OR VALUES REFERRED TO BY THE COMMON LAW DIVIDEND RULES

RULE # DESCRIPTION OF THE RULE ACCOUNT, BALANCE, VALUE

Dividends may not be paid out of share Share capital (and other equity capital. accounts)/ Shareholder's equity.

Accumulated losses may be ignored. Accumulated losses, beginning of year.

Ignore depreciation and losses on fixed assets. Depreciation on fixed assets.

Take- losses and depreciation on current assets Losses on current assets. in account.

Realised profit on fixed assets may be Profit on sale of fixed assets. declared.

Unrealised profit on current assets may be Unrealised profit on current assets. declared.

Unrealised fixed asset revaluations may be Revaluation reserves. . declared.

Consider entire financial position of the Balance sheet. company.

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. Constrai cgs on financial statements

4.3.1. introduction

AC 000 Framework for the preparation and presentation of financial statements (SAICA, 1 990:par.43-.45)has identified three particular constraints on the provision of relevant and reliable information in financial statements, namely timeliness, a Chapter 4 - Imperfections in financial statements 1 00

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.

Directors should continuously attempt to balance the relative merits of timely reporting with the provision of reliable financial information (SAICA, 1 990:par.43). The overriding consideration is how best to satisfy the economic decisionmaking needs that directors may have or that other users of financial statements might have. Dividend decisions fall squarely into the realm of economic decisionmaking as it forms part of the financial and treasury management functions of a company, as determined in paragraph 2.6.4. The timeliness of financial reporting, however, come at a cost.

4.3.3. [Balance between benefit and cost

The benefits derived from financial information as reported in financial statements, should always seek to exceed the cost of providing such information (SAICA, 1 990:par.44). The importance and usefulness of dividends should not be lost out of sight in preparing enough, relevant information for the dividend decision. Dividends are, after all, used extensively by serious investors as a guideline for future investments as discussed in paragraph 2.2.1. The third constraint on

financial statements is the quest to obtain the correct balance between the qualitative characteristics of financial statements. Chapter 4 - Imperfections in financial statements 101

4.3.4. Balance between qualitative characteristics

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):

The different qualitative characteristics of financial statement have to be balanced in order to meet the objective of a set of financial statements (SAICA, 1 990:par.45) that was discussed in paragraph 4.1.

The qualitative characteristics of financial statements may be categorised into four groups namely: understandability; relevance; reliability and comparability (SAICA, 1 990:par.24).

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

Financial statements should be readily understandable to users (SAICA, 1 990:par.25). The directors of a company have control over most of the aspects of the understandability of a company's financial statement as they

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 information contained in financial statements is regarded as relevant when it influences the economic decisions of users by helping them to evaluate past, present and future events or confirming, or correcting past evaluations (SAICA, 1990:par.26).

Statement of Financial Accounting Concepts No. 2 Qualitative Characteristics of Accounting Information concurs with this view by defining relevance as: "...the capacity of information to make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations" (Kirk & Siegel, 1996:55).

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

Information contained in financial statements has to be reliable in order for Chapter 4 - Imperfections in financial statements 1 03

it to be free from material error and bias (SAICA, 1990:par.31). Statement of Financial Accounting Concepts No. 2 Qualitative Characteristics of Accounting Information defines reliability as:

"...the quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent" (Kirk & Siegel, 1996:55).

In order to be reliable, financial statements should represent the information

faithfully. Directors may not always have full control over this attribute

because of bias on their part, inherent difficulties in identifying the

transactions and other events to be measured or in devising and applying

measurement and presentation techniques that can convey messages that

correspond with those transactions and events (SAICA, 1 990:par.34).

Financial information should also be presented in accordance with the

substance of transactions or other events and not merely the legal form of

those transactions and events (SAICA, 1 990:par.35). Particular attention

should be paid to the way in which sale documentation is set up to purport

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

be unrealised in substance at the time in order for such profit or revenue to

be distributed as dividends. Examples of such occurrences were discussed

in paragraph 3.10. and 3.11.

Financial statements should furthermore be neutral (SAICA, 1 990:par.36),

also with reference to how information on dividends are provided to

investors. Investors should be given the opportunity to digest the

information and to make their own conclusions from it about the future value

of dividend streams and investments held.

Another issue to consider in setting reliable financial statements is that of

prudence. Prudence is that feature of financial statements that would cause revenue and profits to be recognised and included in the income statement Chapter 4 - Imperfections in financial statements 104

of a company when realised while provision should be made for all known

liabilities, expenses and losses whether the amount is known with certainty

or not (SAICA, 1974:par.07). Statement of Financial Accounting Concepts

No. 2 Qualitative Characteristics of Accounting Information states that 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

rules as set out in chapter 3, the fundamental accounting concept of

prudence should be considered at all times. Failure to do so (as discussed

in paragraph 3.8. and 3.10.) could lead to the misuse of the common law

dividend rules in the calculation of profit available for distribution as dividends.

The last reliability factor to consider is that financial information shduld be

complete within the bounds of materiality and cost (SAICA, 1 990:par.38).

Materiality and cost restrictions should not affect the calculation of

dividends adversely. The calculation can be based on a normal set of

financial statements as long as the financial statements are prepared in

accordance with generally accepted accounting practice as was discussed in paragraph 4.2.

4.3.4.4. CompavabiDity

The qualitative characteristic of comparability relates to the comparability of the financial statements of a company from one period to another (SAICA, 1990:par.39). The control over comparability is not in the hands of investors. Investors will be at the mercy of the directors who are responsible for setting the financial statements. Directors who apply the requirements of the comparability feature will make it easier for both investors and themselves who make decision based on dividends or decisions on dividends. Comparability of financial statements from one period to another will normally fall by the wayside once the misuse of common law dividend rules occur, for example when dividends are paid from unrealised profits on Chapter 4 - Imperfections in financial statements 1 05

fixed assets from time to time when a company does not earn sufficient trading profits.

Comparability should also be considered at a broader level in the dividend

decision. It was determined in paragraph 2.2.1. that the dividend decision

is an important one for investors or potential investors. Comparability with

the dividend policies of similar companies in the same sector should be considered by directors on an ongoing basis.

4.3.5. Conclusion

The constraints of timeliness, a balance between benefit and cost and a balance

between the qualitative characteristics of financial statements should be considered by the users of financial statements.

The application of appropriate accounting standards and the principles covered by the qualitative characteristics normally result in financial statements that convey

what is generally understood to be a true and fair view of, or as presenting fairly such information (SAICA, 1990:par.46). If these standards and principles are not applied, decisions such as those on dividends may be inappropriate.

The lack of the application of these standards and characteristics are not the only imperfections in financial statements.

4.4. Enhancing pmfit at the expense of the balance sheet

4.4.1. Ontvoduction

Accounting profit as reflected in the income statement of a company is the starting 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

by companies to increase reported accounting profit.

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.

4.4.2. C3anges to depveciation policies

Changes to the depreciation policy of a company without good reason would probably relate to management's attempt to enhance profits. Directors may consider it to be in the best interest of a company to keep the depreciation charge as low as possible in order to minimise the effect of the depreciation expense on accounting profit.

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.

RESULTS BASED ON RESULTS BASED ON NEW CURRENT DEPRECIATION DEPRECIATION POLICY POLICY

Turnover R 150m R 150m

Less cost of sales R 55m R 55m

Less depreciation R 25m R 10m

Gross profit R 70m R. 85m

4.4.3. Capitalization of interest

The capitalization of interest commonly occurs in the development of new property assets when interest is accumulated in the cost of the assets. The impact of the interest bill is deferred until such time as the new property has been fully developed. Advocates of the technique base their theory on the matching of revenue from the development with the associated expenses including interest. The application of the technique creates important timing differences in reported profit. Companies with apparent robust profits have found that profits appear less impressive once a high deferred interest bill is brought back to the income statement, revealing an inability to service debt (Ellis & Williams, 1 993:1 52).

The capitalization of interest or borrowing costs are, however, allowed as an alternative treatment to the immediate recognition of interest in the income statement. AC 114 Borrowing costs (SAICA, 1995a:par.04,.05,.11) states that 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.

4.4.4. Accounting for goodwill

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

statement of a company. The goodwill referred to is the excess of the purchase

price of an asset over the net asset value acquired. There are two bases that may

be used in accounting for goodwill (Ellis & Williams, 1 993:1 52).

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

distribution as dividends is affected on a yearly basis as current profit is reduced by

the quantum of the write-off:

The second option is to charge goodwill directly to the accumulated reserves of a

company. The reserves of the company will consequently be reduced whilst the

current profitability of the company will not be affected. Accumulated -reserves in

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.

4.4.5. rand accounting

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

statements of United Biscuits plc. reads as follows:

"A fair value is attributed to brands at the date of acquisition by the group

and this is treated as an intangible asset. The value is calculated by

multiplying the earnings of the brand by a factor determined by the brand's

strength. No depreciation is provided on these assets but the directors

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 application of such a policy as opposed to the classification of brands as

goodwill, has a positive effect on current year profitability.

The saving resulting from techniques such as brand accounting may have a positive

effect on profitability, but it is doubtful whether companies will always have an

equal amount of cash available to service cash dividend payments.

4.5. The difference between profit and cash

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 to maximise cash (Singleton-Green, 1 995:44). An uneducated investor might be faced with the question why he is not receiving cash dividends while the company he has invested in appears to be very profitable. Some of the reasons for an abundance of profit but a lack of cash dividends might relate to: timing differences between the payment or receiving of cash and when transactions

appear in the income statement; the effect of depreciation and other non-cash expenses; accounting transactions which are recorded in the balance sheet but not the income statements such as acquisitions and changes in working capital requirements (Ellis & Williams, 1993:172). Chapter 4 - Imperfections in financial statements 110

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?

Is the company able to fund comfortably its level of dividend payments?

How much cash is being used to service borrowings?

What has happened to the company's spending on fixed assets?

'How important has the disposal of fixed assets and/or business been in terms of generating funds?

Is the company making acquisitions?

What is the funding needs?

Has the company raised new capital?

To what extent has the company increased borrowings?

How has the company cash position changed?

The quality of profit in terms of cash generated from operations should clearly be considered when calculating profit available for the payment of dividends.

4.6. Monetary expression

The financial statements of a company contain information that is expressed in monetary terms. A host of additional factors that cannot be expressed in monetary terms are not reflected in the information available to investors and analysts. Although these factors may 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,

Uliana & Wormald, 1989:141). Chapter 4 - Imperfections in financial statements 111

4.7. Simplification and summagisation

Financial statements are a simplified and summarised record of the highly complex and

diverse economic events that have occurred in a company's environment. The

simplification and summarisation results in a loss of some clarity and detail that is often

required by analysts and investors (Correia et al., 1989:141-142).Directors are in a better

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 may be defined as:

"The occurrence of a sustained rise in the general level of prices or as a process of

continually rising prices" (Westaway & Weyman-Jones, 1 984:243).

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

wealth of an entity is directly affected by the purchasing power of money reflected in

inflation statistics (Mathews & Perera, 1991:167).

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 1 1 2

TABLE 4.4. FACTORS AFFECTING THE ABILITY TO PAY DIVIDENDS

Accounting

lo- income

Earning power Dividend paying Expected value of

ability shares

Calculation of

future cash flows

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).

AC 201 Disclosure of effects of changing prices on financial results (SAICA, 1978:par.03,.25) makes it clear that depreciation should be adjusted in order to provide current cost information in the financial statements of a company. Depreciation is one of the contentious elements of the common law dividend rules which was discussed in paragraph 3.7. Apart from the general effect of inflation on the elements of the dividend calculation, depreciation should, therefore, specifically be adjusted for the effect of inflation. The inflation adjusted depreciation expense of a company that may be ignored in the calculation of the maximum amount available for distribution as dividends will Chapter 4 - Imperfections in financial statements 1 13

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.

4.9. Abnormal and exceptional items

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.

Financial statements may contain a number of imperfections such as the constraints of timeliness, striving for a balance between the benefit and costs of financial statements and striving for a balance between the qualitative characteristics of financial statements. Other 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 1 4

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

too, will be affected by these problems.

Just as the decisions of directors will be influenced by the information in and imperfections

of financial statements, so will financial statements be affected by the decisions of directors.

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 in different ways, therefore, affecting the analysis of a company's financial statements.

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 1 1 5

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.

CORREIA, C; FLYNN, D; ULIANA, E & WORMALD, M 1989: Financial management; second edition. Cape Town: Juta & Co, Ltd.

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.

SINGLETON-GREEN, B 1995: What do shareholders want? Accountancy, May 1995 Volume 115 No 1221: 44.

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 SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1974: AC 101 Disclosure of accounting policies. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1978: AC 201 Disclosure of effects of changing prices on financial results. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1990: AC 000 Framework for the preparation and presentation of financial statements. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1995a: AC 114 Borrowing costs. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1 995b: AC 103 Net profit or loss for the period, fundamental errors and changes in accounting policies. Johannesburg: SAICA.

WESTAWAY, AJ & WEYMAN-JONES, TG 1984: Macroeconomics theory, evidence and policy; fourth impression. New York: Longman Inc.

Chapter 5 - Dividend policies 117

CHAPTER 5 - DIVIDEND POLICIES

"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.

5.2. Mdend policy options

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.

5.3. Residual dividend policy

5.3.1. Characteristics of the policy

A company electing to declare all of its distributable profit as dividends after satisfying internal capital needs, has adopted a residual dividend policy (Reynders, Lambrechts & Scheurkogel, 1 987:544). The policy suggests that dividends should be declared if there are no investment opportunities available in which the company can invest surplus funds at the required rate of return for a given level of risk. The company will invest in projects until the return on the next investment is below the required rate of return. The required rate of return is normally equal to the cost of capital. At that point the company will distribute excess funds by way of a dividend declaration (Correia, Flynn, Uliana & Wormald, 1989:595).

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 1 1 9

consequently also fluctuate from year to year given that the number of issued shares remain unchanged.

An example of the application of the residual dividend policy is provided in Table

5.1. (Correia et al., 1989:597).

TABLE 5.1. EXAMPLE - RESIDUAL DIVIDEND POLICY

The following details pertain to the company in question:

-Earnings R 800 000

-Debt: equity ratio 1:1

-Cost of capital 20%

-Projects available Cost Internal rate of return A R100 000 28% B R135 000 27% C R220 000 25% D R 85 000 24% E R160 000 22% F R120 000 21% G R200 000 19% H R 90 000 17%

Applying the residual theory of dividend policy:

-Acceptable projects being project A to F R 820 000

-Financed 50% by debt. Equity needed R 410 000

-Earnings for the year R 800 000

-Needed for investment R 410 000

-Available for dividends R 390 000

5.3.2. Advantages and disadvantages of the residua0 dividend policy

The advantage of the residual dividend policy centres around the fact that the income of the company is used at an optimum. A decision is made between Chapter 5 - Dividend policies 1 20

whether a shareholder can eventually earn more from internal re-investment in the

company, or profiteering from external investments that he has selected (Reynders

et al., 1987:544).

The disadvantage of the residual dividend policy is that the value of dividends fluctuate on a yearly basis.

The fluctuation in dividends from year to year can be minimised by creating a

dividend stabilization fund for application in leaner years with the objective of

minimising dividend reductions (Reynders et al., 1987:544). The dividend

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.

The second dividend policy that will be discussed is a constant or steadily

increasing dividend policy.

5.4. Constant or steadily increasing dividends

5.4.1. Characteristics of the policy

The characteristics of a constant dividend policy is that a fixed or constant amount

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.

5.4.2. Advantages and disadvantages of a constant or steadily increasing dividend policy

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.

Disadvantages of the constant or steadily increasing dividend policy is that it may Chapter 5 - Dividend policies 122

be problematic to decide on the level of dividend stabilization. A constant dividend-

payout-ratio cannot be achieved which may not be perceived favourably by market

analysts who prefer a constant dividend-payout-ratio. To counter this disadvantage,

a bonus issue or capitalization issue can be awarded to shareholders from time to

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.

5.5. Constant payout ratio

5.5.1. Characteristics of the policy

A constant payout ratio dividend policy dictates that a predetermined percentage

of distributable profit is distributed from year to year. The amount of dividends on

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.

5.5.2. Advantag s and disadvantages of a constant payout ratio

The advantage (Reynders, et al., 1 987:543) of the policy is that an investor will be reasonably assured of a dividend payment every year.

The disadvantage is that the dividend levels can decrease if a company is in sensitive conjuncture or business cycles.

5.6. Stable dividend growth rate

5.6.1. Characteristics of the p licy

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

policy to be feasible (Kriek, 1 995:2).

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.

5.6.2. Advantages and disadvantages of a stable dividend growth rate policy

The main advantage of this policy is that investors are compensated for the

negative effect of inflation (Reynders et al., 1 987:543).

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.

An example of a company applying a stable dividend growth rate policy is The 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

POLICY: OBJECTIVE: ACHIEVEMENT:

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

stated gearing constraint. earnings. compound rate of 1 7,2% per

annum over the last seven

years, at a 'weighted average

cover rate of 2,2.

Chapter 5 - Dividend policies 1 24

TABLE 5.3. THE SOUTH AFRICAN BREWERIES LIMITED DIVIDENDS v EARNINGS IN CENTS PER SHARE

FINANCIAL YEAR EARNINGS/DIVIDENDS COVER RATE % INCREASE IN DIVIDENDS PER YEAR 1989 187,2/84,0 2,23

1990 225,2/101,0 2,23 20

1991 265,0/118,0 2,25 17

1992 290,4/130,0 2,23 .10

1993 • 303,7/137,0 2,22 5

1994 362,4/155,0 2,34 13

1995 465,1/200,0 2,33 29

The fifth dividend policy to be discussed in that of low regular dividends plus extra.

5.7. Low re Si ullar dividends lus extra

5.7.1. Characteristics of the poOicy

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

5.7.2. Advantages and disadvantages of a low regular dividends plus extra policy

An advantage of the policy is that it gives a company flexibility, yet providing a

minimum stable dividend return for investors (Bringham & Gapenski, 1988:471).

A disadvantage is that there is no evidence of a stable dividend ratio for investors and analysts using stability as a benchmark.

5.8. Dividend irrelevance

5.8.1. Characteristics of the policy

the theory of Merton Miller and Franco Modigliani contends that the dividend policy

of a company is irrelevant and that it affects neither the price of a company's

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).

The Miller-Modigliani theory was based on three assumptions, being: no personal or corporate income tax; no share flotation or transaction costs and Chapter 5 - Dividend policies -1 26

no market imperfections (Correia et al., 1 989:598).

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).

Since the Miller-Modigliani theory was documented in 1958, famous modern

economists and scholars such as Stewart and Stern have based their theories on dividend policies on Miller and Modigliani's work.

5.8.2. The Stewart opinion

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

dividends to shareholders is an admission of failure on the part of the management

of a company. They are unable to find attractive investment opportunities to use all available cash. He further says that: "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."

Stewart based his theory partly on an empirical study on dividends conducted by Professors Fischer Black and Myron Scholes whose fundamental findings have

withstood the test of time (Stewart, 1991:55). Their study tested whether the total returns achieved during the period 1936 to 1966 from 25 carefully constructed portfolios depended upon the dividend yield or dividend payout ratios of the underlying shares. Their study revealed that the return to investors was explained by the level of risk and not at all by how the return was divided between dividends and capital gains. Their study further showed that, within a given risk category, some shares paid no dividends, some modest dividends, and otherg a lot. All thege

Chapter 5 - Dividend policies 127

shares, however, experienced the same overall rate of return over time.

Stewart (1991:48) recognises that once investment opportunities are exhausted,

companies should rather pay dividends than make unrewarding investments. In Stewart's opinion the best option is, however, to buy back shares held by

investors. Buying back shares from shareholders is not an option available to

companies in South Africa. Capital reduction in South Africa can only be

accomplished with, among other stipulations, the sanction of the Courts in terms

of section 84 of the Companies Act (South Africa, 1973) if a company has creditors.

5.8.3. The Stern opinion

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

investors can expect to earn elsewhere on identically risky opportunities (Stern,

1978:23,25). Stern, however, contends that it will be difficult to convince

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

importance of dividends statistics have been discussed in paragraph 2.2.1.

5.8.4. Practical a '11) plication of the policy/

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

5.9. The selection of an appropriate dividend policy

The selection of an appropriate dividend policy should take cognisance of the characteristics, advantages and disadvantages of the dividend policy options available to companies. The impact of each of the options on the presentation of the financial statements of a company should be considered as the financial statements of a company may become available to a number of stakeholder groups. The environment in which the company and stakeholders exist should be considered.

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).

A number of prominent companies have formally acknowledged the role of stakeholders. The South African Breweries Limited has formalised the company's view in the group financial review that is reflected in Table 5.4. (The South African Breweries Limited, 1995:11).

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

distribution of this wealth - to all stakeholders - is necessary and desirable.

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, creating considerable job opportunities.

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.

5.10. The Reconstrucdon and Deveopment Program

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

legitimacy" (Anon., 1994:1) Chapter 5 - Dividend policies 1 32

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 by the collective dividend policies of companies.

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.

The implementation of an appropriate dividend policy should be followed by taking' cognisance of other pertinent dividend rules and the selection of an appropriate form of dividends that may be paid. These issues will be discussed in chapter 6 of this thesis. Chapter 5 - Dividend policies 1 33

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.

CORREIA, C; FLYNN, D; ULIANA, E & WORMALD, M 1989: Financial management; second edition. Cape Town: Juta & Co, Ltd.

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.

KPMG 1 995: Toolkit for the Company Director. Johannesburg: KPMG.

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.

REYNDERS, HJJ; LAMBRECHTS, IJ & SCHEURKOGEL, AE 1 987: Finansiele bestuur; derde uitgawe. Pretoria: J.L. van Schaik (Edms) Bpk.

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

STERN, J 1 978: Why pay dividends? Management, December 1 978: 23-25.

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

CHAPTER 6 - RULES FOR THE PAYMENT OF, AND DIFFERENT FORMS OF DIVODENDS

"The greater the number of laws and enactments, the more thieves and robbers there will be." - Lao-tzu (Peter, 1977:292).

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. Rules for the payment of dividends

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.

6.2.2. Dividend rules in the Companies 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

or similar stipulations in their articles of association.

The rules are provided in line 84 to 90 of Table A which is applicable to public

companies with share capital, and line 83 to 89 of Table B which is applicable to

private companies with share capital. The rules can be summarised as follows:

a company may declare dividends at the occasion of an annual general

meeting of the company;

dividends declared by the annual general meeting may not exceed the

amount recommended by the directors;

the directors may, from time to time, pay an interim dividend to the

members of a company;

no dividends shall be paid otherwise than out of profits;

no dividends shall bear interest gainst the 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

by the directors at their discretion;

the directors may carry reserve funds forward which they may think prudent

not to divide;

persons entitled to a share in dividends shall be given notice of their

entitlement;

every dividend or other moneys payable in cash in respect of shares may be

paid by cheque, warrant, coupon or otherwise as the directors may from

time to time determine, and shall, if paid otherwise than by coupon, either

be sent by post to the registered address of the member entitled thereto or

be given to him personally, and the receipt or endorsement on the cheque

or warrant of the person whose name appears in the register as the

shareholder, or his duly authorized agent, or the surrender of any coupon

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

registered address of any member, whether or not it was so sent at his

request (South Africa, 1973). Chapter 6 - Rules for the payment of, and different forms of dividends 137

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.

6.2.2.1. Risk of personal! liabillity for directors

The directors of a company should consider their own disposition as well as the impact of the payment of dividends on the company or its creditors. Directors may be held personally responsible without any limitation of liability for all or any of the debts or liabilities of the company as the Courts may direct. Circumstances that may give rise to such onerous obligations occur when any business of the company was or is being carried on recklessly or with intent to defraud creditors of the company or any other person or for any fraudulent purpose as intended by section 424 (South Africa, 1973).

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).

6.2.2.2. Purpose of the dividend payment

The purpose of the dividend payment should be considered carefully. Dividends that are paid to current shareholders in order to provide them with funds with which they can purchase additional shares in the company or its holding company, could invoke the prohibition in section 38 of the Act (South Africa, 1 973). Section 38 (1) states the following:

"No company shall give, whether directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or Chapter 6 - Rules for the payment of, and different forms of dividends 138

subscription made or to be made by any person of or for any shares of the

company, or where the company is a subsidiary company, of its holding

company."

The scope for the application of section 38 is very wide as it is not restricted

to circumstances where financial assistance leads to a reduction of the

capital of a company. The impoverishment test that is ordinarily applied by

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)

800-801 (Cilliers, Benade, Henning, Du Plessis & Deport,1 992:322).

Companies running a risk of dividend payments falling in the net of section

38 can still pay dividends and publicize that the purpose of the payment is

to provide a return on the investment of shareholders. A heavy burden of

proof would then exist to show the contrary.

6.2.2.3. Limitation on borvowing powers of directors

Directors may elect to obtain external funding in order to pay cash

dividends. Companies who have accepted the articles of association in

Schedule 1 (or similar stipulations) of the Act will have a maximum amount

of loan funds that may be obtained by directors without prior approval of

shareholders at a general meeting. Line 60 of Table A and line 61 of Table

B of Schedule 1 puts a ceiling on the borrowing powers of directors at one-

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

decision to pay dividends from external funding will be reliant on a number

of factors.

6.2.3. Obtaining extern& funding in order to pay dividends

The decision of the directors of a company to obtain external funding in order to

pay cash dividends should take heed of a number of factors. Chapter 6 - Rules for the payment of, and different forms of dividends 139

The first of these factors is the current level of external borrowings of the company.

As stated in paragraph 6.2.2.3. the directors of a company may be limited in the

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

exceeding the borrowing powers of directors at a general meeting.

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

financial statements and management accounts of a company should be taken into

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

balance sheet and income statement assume no intention or necessity to liquidate

or curtail significantly the scale of operations (SAICA, 1974:par.04). Both the

balance sheet and income statement of a company will be influenced by additional

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

the income statement.

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,

however, be taken with regards to the deductibility of interest paid on external

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.

6.2.4. Restrictive loan covenants

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.

6.2.5. Disclosure requirements

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).

The disclosure and calculation of dividends per share is explained in AC 104 Chapter 6 - Rules for the payment of, and different forms of dividends 141

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.

Changes in the number of equity shares can result from an issue of shares; rights issues at less than fair value; capitalization issues; bonus issues; share splits; share consolidations; share issues in terms of conversion rights or reductions in equity share capital (SAICA, 1992:par.11).

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

6.3. Different forms of dividend payments

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.

6.4. Cash dividends

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 declaration of final dividends are in the hands of shareholders as discussed in paragraph 6.2.2. Final dividends become payable at the time of declaration.

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 creation of the liability:

Dr. Retained earnings

Cr. Dividends payable

At the time of the actual payment of the dividends the liability will be reversed with the following journal entry:

Dr. Dividends payable

Cr. Bank and cash

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

and Unihold Ltd (The Investors Guide, 1996:222,235,288,310,328,396,430).

6.5. Bonus dividends

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,

therefore, a share of past profits that is distributed occasionally instead of periodically.

Bonus dividends may be declared in a number of forms such as cash dividends or

capitalization awards as long as the bonus dividends are sourced from prior year

accumulated profits (Van Dorsten, 1993:27). Chapter 6 - Rules for the payment of, and different forms of dividends 144

6.6. Dividends in specie or kind or property

Dividends in specie or kind or property are dividends payable in the form of assets. This form of dividends constitutes non-reciprocal transfers of non-monetary assets from a 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

Investment Trust [1894] 2 Ch 239 (CA) at 265 by saying:

"If, therefore, the company has any assets which are not its capital within the

meaning of the Companies Act, there is no law which prohibits the division of such

assets among the shareholders" (Van Dorsten, 1993:31).

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 readily divisible. Although it may be impossible to divide a building, shares held as 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 its own shareholders (Kieso & Weygandt, 1986:663).

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

declaration of dividends the assets transferred to shareholders should be revalued at a fair price in order to recognise a consequent loss or profit. The loss or profit is equal to the difference between the fair value and the carrying value of the property at the time of the declaration. The value of the dividends declared may then be recorded as a debit to accumulated earnings and a credit to the dividends payable liability account. At the distribution of the dividends, the dividends payable liability is debited and the asset account credited. An example of the accounting entries for the payment of dividend in specie is set out in Table 6.1. (Kieso & Weygandt, 1986:664)

TABLE 6.1. EXAMPLE - DIVIDENDS IN SPECIE

Trendier Ltd transferred some of its investments in marketable securities costing R1 250 000 to shareholders by declaring a property dividend on December 28, 1985, to be distributed on

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

the books and records of Trendier Ltd are as follows:

At the date of declaration, December 28, 1985:

Dr. Investment in securities R 750 000

. Cr. Profit on appreciation of securities R 750 000

Dr. Accumulated earnings (property dividends declared) R 2 000 000

Cr. Dividends payable R 2 000 000

At the date of distribution, January 30, 1986: Dr. Dividends payable R 2 000 000

Cr. Investment in securities R 2 000 000

6.7. Share splits

6.7.1. The nature of share splits

The Committee on Accounting Procedure of the American Institute of Certified

Public Accountants defines share splits in Accounting Research Bulletin No 43 of 1953 as: Chapter 6 - Rules for the payment of, and different forms of dividends 146

...an issuance by a company of its own ordinary shares to its ordinary shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price and, thereby, obtaining wider distribution and improved marketability of the shares" (Gellein, Sutton & Rubin, 1983:28-14).

Although a company has no intention to distribute earnings at the time of a share split, shareholders receive a payment from a company in the form of new shares. Such a receipt can be regarded as a form of return on capital as it may increase the marketability of shares. A share split results in an increase in the number of shares outstanding and a corresponding decrease in the par value per share (Kieso & Weygandt, 1 986:669). The total value of the share capital account will remain constant.

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.

6.7.2. Companies Act r quirements for share spilits

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

6.7.3. Disadvantages of share splits

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.

6.7.4. Advantages of share splits

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).

6.7.5. Accounting for share splits

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.

6.7.6. The prevalence of share splits in South Africa

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

6.8. Capita0ization awards

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.

6.9. Scrip dividends

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

Limited (Voogt, 1995:39).

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

of capitalization awards in chapter 7 of this thesis. Chapter 6 - Rules for the payment of, and different forms of dividends 1 50

BIBLIOGRAPHY

ANDERSEN, RC 1994: Dividend shares. Financial Mail, December 9 1994: 15.

CILLIERS, HS; BENADE, ML; HENNING, JJ; DU PLESSIS, JJ & DELPORT, PA 1992: Korporatiewe reg; tweede uitgawe. Durban: Butterworths.

CORREIA, C; FLYNN, D; ULIANA, E & WORMALD, M 1989: Financial management; second edition. Cape Town: Juta & Co, Ltd.

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.

McGOUGH, EF 1993: Anatomy of a stock split. Management accounting, September 1993: 58-61.

PETER, L 1 977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.

REYNDERS, HJJ; LAMBRECHTS, IJ & SCHEURKOGEL, AE 1 987: Finansiele bestuur; derde uitgawe. Pretoria: J.L. van Schaik (Edms) Bpk.

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.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1974: AC 101 Disclosure of accounting policies. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1992: AC 104 Earnings and dividends per share. Johannesburg: SAICA.

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

CHAPTER 7 - CAP 1T LIZ TION AWA "'DS

"It's a kind of spiritual snobbery that makes people think they can be happy without money. " - Albert Camus (Peter, 1 977:339).

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).

The payment of capitalization awards as a form of return on the capital invested in a company have since then remained entrenched in the South African economy and is not at all an uncommon, at least among companies that are listed on the Johannesburg Stock Exchange.

Capitalization awards are issues of a specific nature and a number of definitions may be attributed to capitalization awards.

7.2. Definitions for ca itallization awards

The Committee on Accounting Procedure of the American Institute of Certified Public Accountants defines capitalization awards in Accounting Research Bulletin No. 43 as:

"...an issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action

is prompted mainly by a desire to give the recipient shareholders some ostensibly Chapter 7 - Capitalization awards 1 53

separate evidence of a part of their respective interests in accumulated corporate earnings without distribution of cash or other property which the board of directors deems necessary or desirable to retain in the business" (Gellein, Sutton & Rubin, 1983:28-14).

Further, capitalization awards may be defined as the non-reciprocal issuance by a corporation of its own shares to its shareholders on a pro rata basis (Kieso & Weygandt, 1986:666).

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).

Capitalization awards are characterised by the distribution of additional shares in a company that does not change the total value of a shareholder's position. For example, if a company der:lared a 10 percent capitalization award and an investor owned 100 shares, he would 10 additional shares at the payment date. The total value of the company remains the same although the investor now owns 110 shares in the same company (Johnson, 1983:112). The proportion of the shares held by the individual investor does not change in relation to the shareholding of the other investors in the company, neither does the book value of his investment change as will be discussed in paragraph 7.8.

Regardless of the definition attributed to capitalization awards, a number of prominent Chapter 7 - Capitalization awards 154

South African companies have issued shares to their shareholders in this manner.

7.3. The prevalence of capitalization awards in South Africa

Newspapers and periodicals in South Africa frequently carry announcements to the shareholders of companies in order to make them aware of capitalization awards that have been made to them. Examples of prominent listed South African companies who have ventured down the capitalization award route are displayed in Table 7.1. (The Investors' Guide, 1996:79,171,172,252,277,353,416,440).

TABLE 7.1. SOUTH AFRICAN COMPANIES ANNOUNCING CAPITALIZATION AWARDS

COMPANY TERMS OF THE AWARDS DATE DECLARED

o Anglo American Platinum 0 1 ordinary share of 88 cents for every 15/08/1995 Corporation Ltd 100 held

o Everite Group Ltd 0 2 for 1 share 27/11/1992

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

o Rustenburg Platinum 0 1 share of 162 cent per share for 01/09/1995 Holdihgs Ltd every 100 held

0 Toco Holdings Ltd 0 6 capitalization shares for every 100 30/06/1995 held

o Waltons Stationary Co. Ltd 0 1 ordinary share for every 100 held @ 25/01/1994 675 cents per share

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. Reasons for the payment of capitalization awards

7.4.1. Introduction

Accounting and management literature provide scholars with a number of reasons for the payment of capitalization awards to the shareholders of companies as opposed to any other form of dividends. These reasons vary in nature and importance depending on the goals of a company. The first of many reasons that may be forwarded relates to control over the earnings rate of a company.

7.4.2. Reducing the rate of earnings

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

The "weighted average number of shares" to be applied in the calculation of

earnings per share is defined in AC 104 Earnings and dividends per share as the

number of shares determined by relating the portion of time within a reporting

period that a particular number of shares has been entitled to share in the earnings

of a company to the total time in that period (SAICA, 1 992:par.08).

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

return a decrease in the earnings rate of the shares of a company.

The decreased earnings rate of shares now have to be agreed to the return earned

on the capital employed in a company. Return on capital employed is one of the

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 a guide to determine whether an adequate return is being generated on funds

employed. Capital employed is defined as the tangible net assets of a company

(Collier, Cooke & Glynn, 1988:55).

As the return on capital employed is a measure of the adequacy of the return which

is being generated on the funds invested in a company, it is prudent to pay

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

information that investors may use in their investment decisions.

The payment of capitalization awards in order to reduce the rate of earnings or

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.

A second reason for the payment of capitalization awards relates to the marketability of the shares of a company or the lack thereof.

7.4.3. Improving the marketability of shares

7.4.3.1. Introduction

The payment of capitalization awards may be utilised in order to improve the marketability of the shares of a company (Woods, 1977a:232). This second justification for the payment of capitalization awards will only refer to shares in public companies. In terms of section 20 of the Act, shares in private companies may not be offered to the public (South Africa, 1 973) and will, in this regard, not be addressed in this thesis.

Shares in public companies are generally quoted on the Johannesburg Stock Exchange - (hereafter referred to as the JSE). In order to measure the marketability and rate of trading of shares on the JSE, the liquidity of the market should be investigated.

7.4.3.2. Liquidity on the JSE

The liquidity or level of trading on a stock exchange is a major determinant of the success of the market, both nationally and internationally. The larger the turnover on a stock exchange, the more efficient and effective will the market generally be to seekers of capital and investors. Seekers of capital . will be able to identify the cheapest prices. Investors will be able to identify relative maximum value in pricing information. Both seekers of capital and Chapter 7 - Capitalization awards 158

investors will be able to get faster immediate order fulfilment (The JSE, 1994:273).

The liquidity on a stock exchange can be measured using a number of methodologies. One being the measurement of the total market value traded over a period of time expressed as a percentage of the total market capitalization value as at the end of the measurement period. The 1994 study by the JSE on the future restructuring of the JSE declared emphatically that: "...the liquidity on the JSE is unsatisfactorily low" (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)

YEAR TURNOVER Rm MARKET RATIO RATIO %, EXCLUDING CAPITALIZATION Rm % PYRAMID COMPANIES

1988 11 247 291 660 3,85 6,42

1989 20 720 414 042 5,00 8,34

1990 23 912 386 510 6,18 10,31

1991 ' 22 231 508 270 4,37 7,28

1992 22 134 501 324 4,41 7,35

1993 44 079 737 632 5,97 9,95

The significance of liquidity on the JSE in an international perspective is reflected in Table 7.3. The statistics in this table were based on the annual returns submitted to the Federation Internationale des Bourses de Valeurs

(International Federation of Stock Exchanges) as at 31 December 1992. Chapter 7 - Capitalization awards 159

TABLE 7.3. JSE v OTHER WORLD EXCHANGES

AMOUNT JSE

MEASUREMENT LARGEST MEDIAN AVERAGE JSE SMALLEST RANK

Market Capitalization

Value (US$ billions/

a domestic shares ' 3 797,64 104,72 330,61 148,68 3,23 12

Liquidity:Idomestic

turnover velocity) 235,3% 34,0% 44,8% 5,2% 1,0% 38

Market Turnover:

(US$ billions)

o domestic shares 1 628,78 17,34 133,2 7,75 0,12 30

0 all shares 1 745,47 27,25 135,6 8,50 0,29 31

Number of listed

companies:

0 domestic 3 852 363 637 642 59 13

o all 4 113 380 715 671 62 13

o foreign as a % 73,3% 4,1% 15,8% . 4,3% 0% 20

Average Domestic

Company Size:

CUSS millions) 2 061,4 245,6 410,8 231,6 1,9 22

Fund raising

effectiveness: funds

raised by existing

companies as a % of .

total trading value 154,8% 2,6% 9,7% 50,2% 0,7% 2

Relationship to GNP:

% market capitalization

to GNP (as at 31/3/1991) 184,6% 37,0% 50,9% 184,6% 0,5% 1

Concentration (size):

top 5% of companies

ranked by market

capitalization as a % of

market capitalization 77% 57% 56% 61% 32% 16

Concentration (liquidity):

top 5% of companies

ranked by trading value

as a % of total trading

value 86% 51% 53% 60% 15% 14 . Chapter 7 - Capitalization awards 160

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

in correlating the information in the table. The "median" is defined as the

exchange ranked 21st for each of the measurements. The "average" is the

arithmetical division of the aggregate for those market statistics available (The JSE, 1 994:279).

An analysis performed by the JSE of the statistics contained in Table 7.3.

reflects a number of factors. Firstly, the number of foreign companies on the

JSE is limited, reflecting investment sanctions prior to the 1994 democratic

elections in South Africa as well as exchange control restrictions which are

still in place. Secondly, liquidity concerns are not a South African

phenomenon as it is a global concern. Thirdly, the concentration of market

capitalization in respect of the shares of larger companies traded on the JSE

is high (but in line with certain other exchanges) which is a contributing

factor to poor turnover velocity (The JSE, 1 994:279).

In general, shares on the JSE do not change hands frequently and are not

very marketable. The illiquidity of shares on the JSE have a number of

causes.

7.4.3.3. Causes for the poor Hquidity on the JSE

The study which was conducted on the future structure of the JSE also

included a research questionnaire in which respondents were asked to rate,

on a scale of 1 to 5 (1 being of - - e least importance to 5 being of great importance) the causes of the poor liquidity on the JSE (The JSE,

1994:167). The results of the responses are reflected in Table 7.4.

When focusing on the payment of capitalization awards, the following are

important reasons for the lack of liquidity on the market:

concentration of economic power;

pyramid companies and

the high prices of shares. Chapter 7 - Capitalization awards 161

TABLE 7.4. PRIMARY CAUSES FOR THE LACK OF LIQUIDITY

CAUSES GIVEN OVERALL RATING

Income tax uncertainty on the sale of equities 4,41

Foreign. exchange control 4,40

Marketable Securities Tax 3,98

Concentration of economic power 3,83

Absence of discretionary savings (i.e. absence of private investors) 3,73

Bear Sale requirements 3,32

Lack of market-makers 2,99

Pyramids 2,86

Inadequate minimum spread requirements 2,57

Cost of dealing 2,51

High prices per share (i.e. shares should be split) 2,33

Quick settlement requirements 2,17

Inadequate transparency and time and price priority for small investors 1,93

Cost of dealing 1,65

These problem areas need to be addressed by effective solutions.

7.4.3.4. A solution for the lack of liquidity

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.

A capitalization award would increase the number of shares in issue for a particular company, in turn increasing the possibility that existing shareholders would sell the additional shares issued to them on the open

market. Furthermore, an increase in the number of shares in issue could decrease the market price at which shares are traded on the JSE (given that the inherent value of the company remains stable), making shares more Chapter 7 - Capitalization awards 1 62

affordable and marketable.

The affordability and marketability of shares could achieve an important secondary objective of the restructuring of the JSE, being encouraging share ownership by non-institutional investors (The JSE, 1994:78).

A listed company that has attempted to increase the shareholding of non- institutional investors in its share capital, has been Foschini Limited.

7.4.3.5. Exam& - Foschini Limited

Foschini Limited is a large retailer of clothing and jewellery through a network of chainstores which includes Foschini, Markhams, American Swiss, Sterns and Pages. The company paid capitalization awards during its 1993 and 1994 financial years ending 31 March thereby increasing the number of shares potentially available for purchase on the JSE.

Although the number of individual investors owning shares in the company increased over the periods under review, the shareholding of these individuals decreased as a percentage of the total shares in issue. The Foschini share price rose sharply over this period but the year-on-year increase in the market price of shares was lower than the increase in the market capitalization of the company, therefore, making the share a good investment. The effects of the Foschini Limited capitalization award is reflected in Table 7.5. (Year-on-year increases reflected in brackets in Table 7.5.)

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 co co II

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n c n s awa nce t a p idu io inee ide l ra ke re res iv f cap m ta '000) d Tru OSCHINI r ha R F In Comp No Prov o Pens Insu # o ( Sha Mar s II II To Chapter 7 - Capitalization awards 164

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

of the capitalization awards was approximately 2,4 times. In declaring all

taxed earnings as capitalization awards, the company apparently had two

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

regarded as dividends whilst the shares issued in excess of the sustainable

dividend policy were issued to take advantage of favourable market

conditions for the company's shares in order to contribute to an increased

market capitalization and secondly to improve the marketability of the shares

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

The general, marketability of shares on the JSE is _very poor. Important

reasons for this lack of liquidity is, among others, the concentration of

economic power, pyramid companies and the high prices of shares.

Capitalization awards may offer a solution to some of these problems

through an increase in the number of shares in issue. In practice the success

of such a plan is, however, doubtful.

A third justification for the payment of capitalization awards, is the signal

conveyed by the payment.

7.4.4. Signalling earnings potential

Peterson, Millar and Rimbey recently conducted research on the signals sent out by

capitalization awards. The results of the questionnaire used in the research

supported their hypothesis that reductions in distributable reserves at the time of Chapter 7 - Capitalization awards 1 65

a capitalization award are perceived as positive signals by investors (1996:249).

The payment of capitalization awards are viewed as conveying information regarding the directors' outlook for the future earnings of the company. In declaring capitalization awards from retained earnings, directors are seen as signalling their confidence in being able to replenish retained earnings with future earnings streams (Peterson et al., 1996:242).

The nature of the payment of capitalization awards brings scholars to a fourth reason for the issuance.

7.4.5. Conserving cash

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).

7.4.6. Making share capital representative of funds permanently employed

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

profit of a company is represented by non-cash or non-liquid assets that cannot be

distributed by way of a cash dividend without a serious disruption to the business.

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.

7.4.6.1. The nature of reserves (reason 1)

The balance sheet of a company may reveal two types of reserves. The first

being non-distributable reserves and the second distributable reserves. Non-

distributable reserves will be discussed first.

The Act dictates, in sections 76 and 98, that the share premium account

and capital redemption reserve fund of a company are not distributable

except in a number of specific circumstances (South Africa, 1973). The

articles of association of a company may further stipulate that any other

reserve may not be distributed or may only be distributed with specific

authority. Reserves that do not fall in any of these categories will be deemed

to be distributable in terms of the Act and articles of association, regardless

of the description given to an account or balance.

The statutory distributable reserves of a company may not necessarily be

represented by cash. When distributable reserves are transferred to the

share capital account at the time of the capitalization award, the nature of

the distributable reserves change. The capitalization award now indicates

that the whole or a portion of the distributable reserves so utilised is tied up

in the assets of a company that are not represented by cash (Woods,

1977a:233).

There are two consequences to this step (Woods, 1977a:233). The first Chapter 7 - Capitalization awards 167

being that shareholders are not being misled by describing reserves as

"distributable" if the reserves are in reality frozen in the permanent capital

of the company. Secondly, a company could avoid embarrassing demands

from shareholders for higher dividends or from trade unions for higher wages

as accumulated profits have decreased at the reclassification thereof as

share capital.

In the United Kingdom, the reclassification of reserves to share capital at the

time of a capitalization award was also used in order to indicate the

practicability of threatened governmental expropriation of reserves. This was

the case around 1955 when some Labour politicians threatened such

expropriation (Woods, 1977a:233).

The threat of the expropriation of the assets of companies in a number of

forms may not be discounted outright in South Africa. The South African

Government is currently led by the African National Congress with close to

a two-thirds majority. During the 1 990's after the unbanning of the African

National Congress, the economic policies adopted by this party have

changed from a communist-socialist approach to a mixture of socialism and

a free market economy.

7.4.6.2. increased creditworthiness (reason 2)

Share capital and non-distributable reserves form part of the permanent

capital fund to which creditors may turn at the default of a company. As

discussed in paragraph 3.5.2. the view that the paid up share capital of a

company is a guaranteed safeguard for creditors was also underwritten by

the Courts.

A transfer from distributable reserves to the share capital account of a

company at the time of the issue of the capitalization awards would increase

the creditworthiness of a company. Creditors and potential creditors will

benefit as current and past profit that have now been capitalized may not be Chapter 7 - Capitalization awards 168

declared as dividends at same future date (Woods, 1 977a:233).

The sixth reason for the issue of capitalization awards is closely related to

the money markets.

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

remains the same.

There are generally two reasons why a company would want to reduce the gap

between the market price and par value of a share.

7.4.7.1. High share prices (reason 1)

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

prejudiced by a high share price in comparison to par value. This is

particularly relevant in South Africa. As was discussed in paragraph 7.4.3.4.

one of the objectives of the JSE is to broaden the shareholding of individuals

on the market. The goal pertains particularly to black individual investors

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

greater the possibility of an increase in the number of individuals who may

-participate in the market (Woods, 1977b:19).

Black people in South Africa still face .a number of barriers to participation

in the South African economy as described in a 1996 study commissioned

by the National African Federated Chamber of Commerce (Nafcoc). Some of Chapter 7 - Capitalization awards 1 69

these barriers include the lack of competition in the banking industry,

discrimination against small enterprises, unfamiliarity with established

business practices, high collateral and deposit requirements, the

concentration of banks in predominantly white areas and the Usury Act. The

empowerment plan put forward by the National African Federated Chamber

of Commerce (Nafcoc) in order to right some of these wrongs require black

people to constitute 30 percent of the boards of directors of the JSE-listed

companies by the year 2000, to constitute 40 percent of their shareholders,

be given 50 percent of their outsourced work and make up 60 percent of

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.

7.4.7.2. Reducing watering of shares (reason 2)

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

the possibility of the watering of shares in the future. Watering of shares

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

with in section 83 of the Act which contains a number of onerous

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

compared to par value, the greater the proportion of a capitalization award

if the objective is to reduce the possibility of future watering. All of the

distributable and transferable reserves of a company have to be declared as

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

underwriting more desirable (Woods, 1 977b:1 9).

The seventh justification for the payment of capitalization awards focuses

rather on preference shares than ordinary shares as was the case for most

of the reasons above.

7.4.8. Reducing the rights of preference shareholders

In terms of section 193 of the Act, every member of a company owning a share has

a right to vote in meetings of the company. The articles of association of a

company may, however, in terms of section 194 preclude preference shareholders

from voting at the meetings of a company unless:

any dividend payment or redemption payment is in arrears to the preference

shareholders or

a meeting is convened to discuss a proposed resolution which directly

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

voting rights of preference shareholders may be reduced or watered down with a

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

shareholders in the company are consequently•reduced.

The capitalization award to ordinary shareholders does not contravene the Act Chapter 7 - Capitalization awards 171

although it may appear to prejudice the preference shareholders. Gower expressed the opinion that the Act is unsatisfactory in this regard as the rights of a class of shareholders may be substantially reduced (Woods, 1977b:20). The remedies available to prejudiced shareholders in terms of the Act is, however, not very effective.

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.

7.4.9. Taxation considerations

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.

Subsequent to the introduction of STC, the payment of capitalization awards as one

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.

Although capitalization awards as a form of dividends result in a saving of STC, the awards come at a cost.

7.5. The cost of capitalization awards

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.

7.6. Sources for capitalization awards

Capitalization awards may be paid from a number of sources, the first being the Chapter 7 - Capitalization awards 173

distributable reserves of a company. The articles of association of a company should be examined in this regard as it may preclude the issue of capitalization awards from some of the categories of distributable reserves. The statutory non-distributable reserves of a company may also be utilised in two ways in order to pay capitalization awards.

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.

7.7. Accounting for the payment of capitalization awards

7.7.1. Nature of the accounting entries

The declaration of capitalization awards is a decision by the directors of a company to transfer part of the reserves of the company to the share capital accounts on a permanent basis. The assets of the company will not be affected in any way and each shareholder who receives capitalization awards, has the same proportionate interest in the company at the same total value as before the award. The book value per share will, however, be lower as the investor holds an increased number of shares in the company whilst the value of the company has not changed (Kieso & Weygandt, 1986:666).

7.7.2. Value of the transfer

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).

The Accounting Research Bulletin No. 43 of the American Institute of Certified Public Accountants states that: "...the corporation should in the public interest account for the transaction by transferring from retained earned surplus to the category of permanent capitalization (represented by the capital stock and capital surplus accounts) an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings which the shareholder may believe to have been distributed to him will be left, except otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions" (Gellein, Sutton &Rubin, 1983:28-15,28- 16).

In Japan, capitalization awards are normally accounted for by a transfer of an amount equal to the par value of the shares from retained earnings (Cooke, 1993:464).

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

company. The first option to investigate is the issuance at par value. Chapter 7 - Capitalization awards 175

7.7.3. ExampOe - capitalizaVon award at par vahute

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

The board of directors of the company declared a 10% capitalization award on February 24, distributable on March 31 to shareholders registered on the last date of registration of March 15. The capitalization award will be accounted for at par value via the following entries:

February 24 Dr. Retained earnings R 15 000 Cr. Ordinary share capital distributable R 15 000 To record the declaration of a capitalization award, distributable on March 31 being 30 000 shares x 10% = 3 000 shares at R5 par value.

March 15 No entry.

March 30 Dr. Ordinary share capital distributable R 15 000 Cr. Ordinary share capital R 15 000 To record the issue of capitalization shares•to shareholders.

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 Share premium account R 30 000 Total contributed capital R 195 000 Retained earnings R 885 000 TOTAL SHAREHOLDERS' EQUITY R 1 080 000

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.

7.7.4. Example - capitalization award at fair value

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 TOTAL SHAREHOLDERS' EQUITY • R 1 080 000

The board of directors of the company declared a 10% capitalization award on February 24, distributable on March 31 to shareholders registered on the last date Chapter 7 - Capitalization awards 177

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:

February 24 Dr. Retained earnings R 60 000 Cr. Ordinary share capital distributable R 15 000 Cr. Share premium R 45 000 To record the declaration of a 10% capitalization award, distributable on March 31 to shareholders registered on March 15: 30 000 shares x 10% = 3 000 shares 3 000 shares x R20 per share = R 60 000 3 000 shares x R5 per share par value = R 15 000

March 15 No entry.

March 30 Dr. Ordinary share capital distributable R 15 000 Cr. Ordinary share capital R 15 000 To record the issue of capitalization shares to shareholders.

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 Share premium account R 75 000 Total contributed capital R 240 000 Retained earnings R 840 000 TOTAL SHAREHOLDERS' EQUITY R 1 080 000

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.

7.7.5. Accou tip g for (c,ggtalization awards other than from ret ined e r ings

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.

An issue of capitalization awards, other than from retained earnings, will be journalised in the same way as discussed in paragraph 7.7.3 and 7.7.4. except that

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

change accordingly subsequent to the award. Chapter 7 - Capitalization awards 1 79

7 8 Accountin ■!.11 for the recemt of ca itallization awards

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

SHAREHOLDERS' EQUITY BEFORE CAPITAL,- AFTER CAPITALI- ZATION AWARD ZATION AWARD

Ordinary share capital R 150 000 R 165 000

Share premium account R 30 000 R 75 000

Total contributed capital R 180 000 R 240 000

Retained earnings R 900 000 R 840 000

Total shareholders equity R 1 080 000 R 1 080 000

Shares issued 30 000 33 000

Book value per share R 36,00 32,73

(Total shareholders equity/shares issued)

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

BEFORE CAPITALI- AFTER CAPITALI- ZATION AWARD ZATION AWARD

Shares owned 1 000 1 100

Shares in issue 30 000 33 000

Percentage of ownership 3,33% 3,33%

Total book value of investment R 36 000 R 36 000 13,33% x R1 080 000)

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

A number of definitions may be attributed to capitalization awards. The nature of the awards will always centre around an issue of new fully paid-up shares of a company to its shareholders free of cost. Although capitalization awards are classified as a form of dividends, there are a host of reasons that may be forwarded for the issuance. Many of the reasons suit the business objectives of the issuing company more than the needs of the recipients of the awards.

Regardless of the reasons for the issuance, capitalization awards come at a cost that Chapter 7 - Capitalization awards 1 8 1

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

COLLIER, PA; COOKE, TE & GLYNN, JJ 1988: Financial and Treasury Management. Oxford: Heinemann Professional Publishing Ltd.

COOKE, TE 1993: The Impact of Accounting Principles on Profits: The US versus Japan. Accounting and Business Research, Volume 23 Number 92 Autumn 1993: 460- 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.

EVERINGHAM, G & HOPKINS, B 1995:Generally Accepted Accounting Practice (as amended). Cape Town: Juta & Co, Ltd.

FOSCHINI 1992: 1992 Annual reports Foschini Limited, Lewis Foschini Investment Company Limited.

FOSCHI.NI 1 993: 1993 Annual reports of the Foschini Group.

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.

McGOUGH, EF 1993: Anatomy of a stock split. Management accounting, September 1993: 58-61.

NEEDLES, BE; ANDERSON, HR & CALDWELL, JC 1990: Principles of accounting; fourth edition. Boston: Houghton Mifflin Company.

PETER, L 1977: 5,000 Gems of Wit & Wisdom. London: The Bath Press.

PETERSON, CA; MILLAR, JA & RIMBEY, JN 1996: The Economic Consequences of Accounting for Stock Splits and Large Stock Dividends. The Accounting Review, Volume 71 Number 2 April 1996: 241-253.

'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 CONCISE OXFORD DICTIONARY 1982: seventh edition. Oxford: University Press.

THE FOSCHINI GROUP 1994: 1994 Annual reports.

THE INVESTORS' GUIDE 1996: Issue 77. The Johannesburg Stock Exchange. Johannesburg: The Investors' Group (Pty) Ltd.

THE JOHANNESBURG STOCK EXCHANGE 1994: Report of the research sub-committee on the future structure of the Johannesburg Stock Exchange to the Johannesburg Stock Exchange Committee. Johannesburg: The Johannesburg Stock Exchange.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1992: AC 104 Earnings and dividends per share. Johannesburg: SAICA. Chapter 7 - Capitalization awards 184

WOODS, IR 1976: Capitalization Issues v Sharesplits. Businessman's law, 1 May 1976: 169-171.

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

CHAPTER = - SCI OP DOVODENDS

"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

The implementation of dividend reinvestment plans (hereafter referred to as DRPs) have become prevalent in South Africa. DRPs provide shareholders with the opportunity of receiving scrip dividends. Scrip dividends enable existing shareholders to acquire free additional shares in a company, usually calculated at a small discount to the prevailing market price of the shares or to elect to receive cash dividends (Everingham & Hopkins, 1994:489).

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.

.2. Definitions for 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 the place thereof (Everingham & Hopkins, 1994:489).

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.

3. The prevaience of scrip dividends in South Africa

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

COMPANY TERMS OF THE PLAN DATE DECLARED

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 Highveld Steel & 0 1 ordinary shares for every 77 held or a 02/08/1995 Vanadium Corp. Ltd cash dividend of 35 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

0 Tradehold Ltd 0 1,355 ordinary shares for every 100 25/04/1995 held at R31,00 each in lieu of a cash dividend

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.

8.4. Reasons for the peymr Ma of scrip dividends

.4.1. introduction

Accounting and management literature provide scholars with a number of reasons for the implementation of DRP's in order to pay scrip dividends. These reasons vary in nature as different companies have different goals that they wish to achieve through the payment of scrip dividends. The first reason for the payment of scrip dividends relates to the retention of cash in a company.

.4.2. The effect of scrip dividends on the cash position of e company

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).

The payment of capitalization shares merely constitutes a transfer from distributable reserves, share premium or a capital redemption reserve fund to share capital as was discussed in paragraph 7.6. The cash resources of a company will be left mostly in tact the higher the capitalization share acceptance rate of a DRP.

The election of capitalization shares in lieu of cash dividends could generate significant cash savings for South African companies as the acceptance rate of Capitalization shares in terms of DRPs are very high. The acceptance rate of capitalization shares in lieu of cash are frequently in excess of 80% (Everingham & Hopkins, 1994:490).

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.

.4.3. Saving o SIC

.4.3.1. The intvockoction of STC

In 1993 the Minister of Finance announced a reduction in the corporate rate of normal taxation on companies and close corporations from 48% to 40% and introduced a new tax called Secondary Tax on Companies of 1 5% on income that is distributed to shareholders. A dual corporate income tax system was accordingly introduced that was made applicable to all companies and close corporations. The first part of the dual tax was to be levied on taxable income and the other, a secondary taxation on distributed income (SAICA, 1993:par.01). Chapter 8 - Scrip dividends 190

8.4.3.2. The natuve of STC

STC levied on distributed income is not a tax on shareholders but a company tax that should be treated as an expense against the income of a company (SAICA, 1993:par.03). Section 64B (2) of the Income Tax Act dictates that STC should be calculated at a specific rate of the net amount of any dividend declared by a company (South Africa, 1962) .

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).

The introduction of STC created a second or double form of taxation on the earnings of a company. The first being normal taxation on taxable earnings and the second, STC on earnings declared as dividends.

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.

.4.3.3. The calculation of the net amount of dividends decl d

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 calculation of STC is reliant on the definition of dividends as detailed in section 1 of the Income Tax Act that was set out in paragraph 2.2.5. The definition of "dividends" is initially broad, covering "any amount distributed by a company to its shareholders". Thereafter, an explanation is given of a number of payments or awards that are to be excluded from the definition of dividends for the purposes of the Income Tax Act (Wilson, 1994:113).

4.3.4. ExcOu&ons from the definiVon of "dhfi

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".

For the purposes of the discussion of scrip dividends, the following distributions should be excluded from the definition of dividends (as set out in paragraph 2.2.5.):

capitalization shares paid up by means of the share premium account of a company; the nominal value of any capitalization shares awarded to shareholders as part of the equity share capital of a company if such shares are awarded on or after 1 July 1975 and where a company has on or after 1 January'1974 transferred any amount from reserves 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 the amount shall be deemed to the extent that such amount is shown to consist of profits of a capital nature available for distribution by the company Chapter 8 - Scrip dividends 192

to shareholders who in the event of a distribution by the company at any time of profits to be of a capital nature (South Africa, 1 962).

To the extent that shareholders elect to receive capitalization awards in lieu of cash dividends in terms of a DRP, there will be no STC payable on such share distributions, returning a tax saving for the issuing company.

4.3.5. Exam& - The South Aftican reweules °junked

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.

With a 90,1% acceptance rate of capitalization shares instead of cash dividends (Anon., 1995a:9), The South African Breweries Limited, with a final 1995 dividend of 153,0 cents per ordinary share (The South African Breweries Limited, 1995:71) realised a substantial saving on STC of R96 805 351, including the STC payable on residual cash dividends, payable in lieu of fractional entitlements to new ordinary shares (Anon., 1 995a:9).

The saving of R96 805 351 is calculated as follows (The South African Breweries Limited, 1995:71,77):

Number of ordinary shares in issue = 280 927 552 x dividends per share = 153,0 cents Cash equivalent dividends = R 429 819 154,56 x STC at 25% = x25% STC payable on full cash election = R 107 454 788,64 Chapter 8 - Scrip dividends 193

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 cash and profit in the company is as follows: Cash generated from trading profit:Profit before taxation R2 934 million:R2 537,5 million 1.16:1 Chapter 8 - Scrip dividends 194

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.

Although an individual company would save STC to the extent that capitalization awards are taken up at the issue of scrip dividends, the question remains whether the saving should not be regarded as tax avoidance. Tax avoidance would constitute an illegal act. As the payment of capitalization awards fall in the ambit of the Income Tax Act, scrip dividends are accepted as business tools.

.4.4. they ve sons f the payment of scrap dhddends

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

8.5. STC issues to considev at the payment of dividends

.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.

.5.2. NominaD vakne of shaves

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).

8.5.3. Equity cilassification of c 't lization,.:wands

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.

A preference share capitalization award will attract STC, whilst a capitalization issue of ordinary shares will be exempt from STC (Wilson, 1994:113).

.5.4. Wood ng of the scu dhAdend announcement

The wording of the scrip dividend announcement should also be considered carefully. Refer to the examples in Table 8.2. (Wilson, 1994:114).

TABLE 8.2. EXAMPLE - WORDING OF SCRIP DIVIDEND ANNOUNCEMENT

Consider the following two scenarios:

ID Company X declares a dividend to shareholders, announcing that any shareholders who so elects may, in lieu of a payment in cash, receive an issue of capitalization shares in the company.

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.

STC is triggered by a declaration of a dividend.

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

has been declared and a liability to STC incurred.

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

cash out of the company's profits.

If one considers examples of the wording of DRP announcements of South African companies, it becomes clear why companies refer to their scrip dividends as capitalization awards or awards of fully paid new shares. The reason is clearly to Chapter 8 - Scrip dividends 197

ensure that STC is not invoked at the declaration of dividends. Refer to Table 8.3.

Maspero (1994:122) concurs with this view, stating that: "The schemes seem to have been devised within a framework indicating a paranoid awareness of the supposed tax consequences."

TABLE 8.3. EXAMPLE - SCRIP DIVIDEND ANNOUNCEMENTS

The Clicks Group Limited - Terms of the award of capitalisation shares 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 dividend pursuant to the election (Anon., 1995b:7).

Conshu Holdings Beperk - Bepalinqs van kapitalisasie-aandeletoekenninq 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 kapitalisasie-aandeletoekenning sal plaasvind in verhouding van 3,1481 nuwe gewone aandele 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, vereffen word (Anon., 1995c: S4). Continued... Chapter 8 - Scrip dividends 198

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).

8.5.5. lInteRvoup SC61 dvidends

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).

5.6. Effect on future reducdons of capAta

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).

.6.7. Msciosure of SIC

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

accepted accounting practice should be applied consistently (Everingham & Hopkins, 1994:490).

Just as Income Tax legislation have to be considered at the declaration of scrip dividends, so too are there a number of requirements in the Act that need to be adhered to.

.6. Companies Act requivements

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

shares (South Africa, 1973).

8.7. Scalp dividend tams

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).

Subsequent to a capitalization award, a number of shareholders may own odd lots of shares. Issuing companies usually make arrangements with stock brokers for the odd lot shares to be sold within a given time frame at the full market price. This step also encourages shareholders to elect to receive shares instead of cash dividends (Everingham & Hopkins, 1994:494). Trading in odd lots of shares was made possible by a change in the rules of the JSE during 1996.

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

.2. Internationa0 pronouncements

Financial Reporting Standard 4 Capital Instruments (hereafter referred to as FRS 4), issued by the Accounting Standards Board of England and Wales addresses some of the issues relating to scrip dividends (ICAEW, 1994:100-113). In terms of FRS 4 the following rules should be applied:

paragraph 48 states that when a company issues shares as an alternative to cash dividends, the value of the shares should be deemed to be the amount receivable if the alternative of cash had been chosen and paragraph 99 states that where scrip dividends are issued or proposed, the value of shares issued or to be issued should be the amount of the cash dividend. Where the legal form of the share issue is that of a capitalization award, the appropriation should be written back as a reserve movement and the appropriate amounts transferred between reserves and capital to reflect the capitalization of the reserves.

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.

3 ccounting entri s at the date of the decllaraUon of scglp dkidends

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.

.4. Accounting entvies at the finalization of the DRIP

The payment of scrip dividends to individual shareholders will generally be delegated to the independent share registrars of a company. The issuing company would receive a report from the share registrars on the value of cash dividends paid and the number of capitalization shares allotted and issued. Chapter 8 - Scrip dividends 204

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).

If a greater than anticipated number of shareholders elect to receive shares instead of cash dividends, a credit balance may remain on the shareholders for dividends current liability account created at the declaration of the scrip dividends. There are two possible treatments to correct the excess provision. The first option is referred to as the bonus share approach and the second as the reinvestment approach (Hemus, 1992:305).

4.1. The bows she approach

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.

4.2. The reinvestm M approach

The reinvestment approach establishes that the underlying principle of a DRP is that the shareholders are being paid cash dividends that are simultaneously reinvested in the company by way of the issue of new shares. The surplus credit on the shareholders for dividends account should be eliminated by crediting an amount equal to the par value of the excess number of actual shares issued over the anticipated number of shares to share capital and the remaining surplus to the share premium account (Hemus, 1992:304-305). The reinvestment approach is in line with FRS 4 and is also the standard followed in New Zealand.

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.

4.4. PPP° ch sd er inl S uth Afruc

There is currently no South African accounting standard that addresses scrip dividends. As a result, the bonus share approach and the reinvestment approach may be applied. The South African Breweries Limited, as well as all the subsidiaries in the group apply the reinvestment approach (The South African Breweries Limited, 1996:72). Chapter 8 - Scrip dividends 206

.5. Detaed eKarruipOe - accouMhg fo scuip clMdends

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).

A company has in issue 30 000 000 shares of R1 each. It decided to have a capitalization issue, in lieu of a dividend, of 6 shares for every 100 shares held. Shareholders may take cash of 10 cents per share if they do not choose the capitalization shares. Any fractions of shares will be paid out in cash.

The market price per share is presently 200 cents.

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.

The workings are as follows:

Calculation of cash dividend 6% of 30 000 000 x 10 cents R180 000 Odd lots R 3 000 R183 000

Calculation of number of shares issued 94% of 30 000 000 shares 28 200 000 Odd lots R3 000/0,10 30 000 28 170 000 Shares issued 6/100 of 28 170 000 1 690 200

Calculation of cash value of shares Say cash value of shares for dividend purposes is Y 6 x Y = 100 shares x R0,10 R1,66667 Chapter 8 - Scrip dividends 207

4. Calculation of share premium = 1 690 200 shares @ R(1,66667-1,00000) = R1 126 800

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:

Dr. Dividends paid R 3 000 000 Cr. Shareholders for dividends account R 3 000 000

Dr. Shareholders for dividends account R 3 000 000 Cr. Cash R 183 000 Cr. Share capital R 1 690 200 Cr. Share premium R 1 1 26 800

Assuming that the capitalization issue is out of share premium and the reinvestment approach followed, the accounting entries will be as follows:

Dr. Share premium R 1 690 200 Cr. Distributable reserves R 1 690 200

Dr. Dividends paid R 3 000 000 Cr. Shareholders for dividends account R 3 000 000

Dr. Shareholders for dividends account R 3 000 000 Cr. Cash R 183 000 Cr. Share capital R 1 690 200 Cr. Share premium R 1 1 26 800

In both cases the dividends per share should be disclosed as 10 cents per share.

Chapter 8 - Scrip dividends 208

9. Accountin for scull 111) dvWends recahfed lb a hoUn corn an

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.

. 110. Discllosure vequkemen2s

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.

11.ivklends pev shave

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 core determinant of meaningful presentation and disclosure of information is its validity in supporting management's decision making processes. While the accounting philosophy encourages the pioneering of new techniques, it fully endorses the fundamental concepts underlying both the financial and management accounting principles, as enunciated by The International Federation of Accountants, The International Accounting Standards Committee and The South African Institute of Chartered Accountants.

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

ANDERSEN, RC 1 994: Dividend shares. Financial Mail, December 9 1 994: 15.

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., 1995c: Conshu Holdings Beperk. Beeld, 10 Mei 1995: S4.

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.

DAVIES, M; PATERSON, R & WILSON, A 1994: Generally Accepted Accounting Practice in the United Kingdom. London: MacMillan publishers.

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.

EVERINGHAM, GK & HOPKINS BD 1994: Generally Accepted Accounting Practice (as amended). Cape Town: Juta & Co, Ltd.

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.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1992: AC 104 Earnings and dividends per share. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1993: AC 303 Accounting for the dual corporate tax system. SAICA: Johannesburg.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1995: Secondary tax On companies (STC) - intergroup dividends. Integritax, June 1995: 6-8.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1996: STC - wholly owned subsidiaries. Integritax, October 1996: 6-7. Chapter 8 - Scrip dividends 215

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

CHAPTER 9 iDE TOFOCATOON OF PRO LEMS RECOMMENDATl I) HS THERETO

"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.

9.2. Problem numb - The wa , ment of dividends from rofit orr income rr a fu d

9.2.1. Ontro auction

The definition for dividends documented in paragraph 2.2.6. concluded that: dividends is a payment, or allocation, or division of some form; Chapter 9 - Identification of problems and recommendations thereto 217

sourced from profit, income or a fund; made to shareholders and authorised by the board of directors of a company.

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.

9.2.2. Definhn probGerro number 11

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.

9.2.3. l,econnemdat ns - problem number 11

In terms of AC 103 Extraordinary items and prior year adjustments (SAICA, 1985:par.29), which was withdrawn during 1995, all items of income and expenses for a period should be included in the income statement of a company. The term "profit" was not referred to at all in AC 103 Extraordinary items and prior

year adjustments. Appendix AC 103A to AC 103 Extraordinary items and prior year adjustments which provided an illustration for the layout of an income statement, reflected that the term "retained income" should be used to denote the final line in the income statement of a company for the year, showing the net result of income and expense items (SAICA, 1985).

Chapter 9 - Identification of problems and recommendations thereto 218

One of the solutions to problem number 1, is rooted in the introduction of AC 103 Net profit or loss for the period, fundamental errors and changes in accounting policies (SAICA, 1995). In terms of AC 103 Net profit or loss for the period, fundamental errors and changes in accounting policies, the net of income and expenses of a company, should be included in the determination of profit (SAICA, 1995:par.07).

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.

9.3. Problem num err 2 fit hag Hy avail s bi distvibution as dividends

9.3.1. intv duction

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

9.3.2. Defining pvobiem numb& 2

Problem 2 - Accounting profit may not be equal to profit. legally available for

distribution as dividends. Profit legally available for distribution as dividends, may

be greater than accounting profit.

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.

9.3.3. Recommendations - pvobiem numbev 2

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.

Paragraph 66 (2) of Schedule 4 of the Act, that contains the disclosure requirements for a directors' report, requires that any matter which is material to the appreciation of the affairs of the company be disclosed, regardless of whether disclosure is specifically required by the Act (South Africa, 1973).

Irrespective of the amount eventually paid, dividends remain of great importance in investment decisionmaking processes, as discussed in paragraph 2.2.1. Dividend information would surely have to be classified as being material. The directors'

Chapter 9 - Identification of problems and recommendations thereto 220

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. Problem number 3 - omidend payments are authorlsed by the board of dlrectors

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.

.4.2. efining problem num er 3

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.

Shareholders as a group do, however, have to rely on the directors of a company to look after their collective and individual interests. The question remains how the rights of shareholders may be balanced with the prerogative and plans of directors.

9.4.3. RecommendaVons - pvcDbOem number 3

The directors of a company carry a heavy responsibility in order to fulfil their fiduciary duties (discussed in paragraph 2.6.5.), and duties of loyalty, care and skill and attention (discussed in paragraph 2.6.2.). The fulfilment of these duties should be the first line of defense in safeguarding the interests of shareholders as a group and as individuals.

Adherence to the principles in The King Report on Corporate Governance should create a second line of defense in protecting the rights of shareholders. These principles should create a culture of corporate governance in a company. "Corporate governance" may be termed as a system or process by which companies are directed and controlled (KPMG, 1995:5).

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 greater part of the risk in • company.

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.

9.5. Problem number 4 - Accumulate sses in past tr ong periods may be ignore*.

9.5.1. Introducti 111,

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

9.5.2. Defining probiern number 4

Problem 4 - Accumulated losses suffered in past trading periods may be ignored, against generally accepted accounting practice, in the calculation of the amount that may legally be distributed as dividends.

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

9.5.3.1. edrafting of section 286 (3) of the Ac

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).

In 1977 the Accounting Practices Board of SAICA obtained legal opinion on two questions in this regard, being: does compliance with a statement of generally accepted accounting practice, issued by the Accounting Practices Board, constitute compliance with the requirements of section 286 (3) and does non-compliance with these statements constitute a contravention of the requirements of section 286 (3) of the Act

Chapter 9 - Identification of problems and recommendations thereto 224

(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

shall include the matters prescribed by the Fourth Schedule, in so far as they are applicable, and shall comply with any other requirements of this Act; and (b) fairly present the financial position of the company as at the end of its financial year then ended.

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 directors shall cause the annual financial statements to be &awn up so as to comply with paragraph 3 (b); and

the directors shall furnish in the annual financial statements the reasons why it was not deemed appropriate to comply with paragraph 3 (a) and shall provide additional information for the appreciation of the effect on the financial position and the results of the operations of the company, of not complying with paragraph 3 (a)" (SAICA, 1996:17).

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.

9.5.3.2. Redraft g of the Act

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.

9.5.3.3. Havmonisation and htemaVonaNizanon of South Affican Comp ny w

Any proposal for a re-drafted Act, need to take cognisance of legislation elsewhere in the world, particularly in those countries that are seen as South Africa's major trading partners.

Companies Act legislation in the United Kingdom for example, includes stipulations that accumulated losses need to be made up, before dividends are paid from current accounting profit as detailed in paragraph 3.1 3. Similar stipulations should be included in proposed legislation in South Africa. The legality or illegality of the use of the second common law dividend rule will then be apparent and any new Act will conform with standards set in European Law. Chapter .9 - Identification of problems and recommendations thereto 227

9.6. Pit( ierro number 5 - De [I) reciation ma be o (!), no► ed in the caicuiation of profit availlabie for distribution as dividends

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.

9.6.2. Defi 'Ong Iambi rro number 5

Problem 5 - Depreciation may be ignored in the calculation of profit legally available for distribution as dividends. This third common law dividend rule is not in conformance with generally accepted accounting practice.

Based on accounting pronouncements, paragraph 3.7.4.4. concluded that depreciation is the allocation of the cost of the assets of a company over the useful life of these assets. Depreciation is conceptually regarded as an expense to a company. This dividend rule that states that depreciation may be ignored in the calculation of profit available for distribution as dividends, does not conform to accounting standards, which was also the case for problem number 4 which was discussed in paragraph 9.5.

9 ,c.3. Rr commendations - probiem nu r be 5

The recommendations proposed for problem number 4 which was discussed in paragraph 9.5.3.1. and 9.5.3.2., can be applied equally in correcting the conceptual accounting problems created by the application of the third common law dividend rule.

Further, legislation on dividends in the United Kingdom include stipulations that Chapter 9 - Identification of problems and recommendations thereto 228

require depreciation to be taken into account in the calculation of the amount available for distribution as dividends, as discussed in paragraph 3.1 3. 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 third common law dividend rule in line with legislation in other countries.

9.7. Problem number 6 - aiised profit on the 0. vaivation of current assets may be d ciared as dividends

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.

9.1.2. Defining probiem number 6

Problem 6 - Unrealised profits on the revaluation of current assets may be declared as dividends in terms of the sixth common law dividend rule.

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.

.7.3. R men at ions - problem number 6

The recommendations proposed for problem number 4 which was discussed in paragraph 9.5.3.1. and 9.5.3.2. can be applied equally in correcting the conceptual accounting problems created by the dividend rule that allows for the distribution of unrealised profit on the revaluation of current assets.

Furthermore, legislation on dividends in the United Kingdom, which was discussed

Chapter 9: Identification of problems and recommendations thereto 229

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.

9 Probiem number 7 - Unreails profit on the revaivation of fiAed assets may be deciared as dividends

. 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.

2. Defi eamag probi m number 7

Problem 7 - Unrealised profit on the revaluation of fixed. assets may be declared as dividends in terms of the seventh common law dividend rule.

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

.3. Recommendations - pvobiem number 7

The recommendations proposed for problem number 4 which was discussed in paragraph 9.5.3.1. and 9.5.3.2. can be applied equally in correcting the conceptual accounting problems created by the seventh common law dividend rule that allows for the distribution of unrealised profit on the revaluation of fixed assets.

Furthermore, legislation on dividends in the United Kingdom which was discussed 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 take heed of these stipulations in order to prohibit the payment of dividends from unrealised profits on the revaluation of fixed assets either totally or in part. A re-drafted Act should then be in line with legislation elsewhere in the world in this regard.

Proposed legislation to prohibit the payment of dividends from unrealised revaluation reserves, can be limited in part in South Africa, as is the case in the United Kingdom. Unrealised profit may be used in the United Kingdom for the issue of capitalization shares.

Although revaluation surpluses are not statutory non-distributable reserves in South Africa, revaluation surpluses are generally classified as part of the non-distributable reserves of a company. The reclassification of unrealised revaluation reserves to share capital at the time of the payment of capitalization awards should be an accepted alternative for companies, if the transfer is disclosed in detail in the financial statements of a company.

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

(SAICA, 1994:par.43). Revaluation reserves may be used to pay dividends to the extent that depreciation on the revalued amount exceeds depreciation on the original costs. Chapter 9 - Identification of problems and recommendations thereto 231

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. Pr bi rn n Lm nna. 8 - interpretation of u iifi d audit opinions

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.

9.9.2. fining probOr m number 8

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.

The auditor of a company is in a precarious position if he elects to qualify the financial statements of a company on the grounds of the misuse of the common law dividend rules.

The educated investors in a company, particularly institutional investors, may comprehend the reasons for and effect of such an audit qualification. The same may not, however, be said for many a small, individual investor. Small, individual Chapter 9 - Identification of problems and recommendations thereto 232

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.

9.9.3. &commendations - pvobiem nurnbev

9.9.3.1. JSE training progvams

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

investments (The JSE, 1994:87).

These education programs should address the issue of dividends. Specific matters that should be introduced to small individual investors through these

programs, include the following: an explanation of the measures of prosperity, other than dividends,

that may be used in the analysis of a company; reasons why dividend amounts may be greater than accounting profit

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

and scrip dividends;

Chapter 9 - Identification of problems and recommendations thereto 233

explanations for the JSE classification system that indicate companies on the JSE boards with qualified audit reports and late submission of financial statements; advantages and disadvantages for the election of either cash or capitalization awards at the declaration of scrip dividends and the voting rights of shareholders in a company.

9.9.3.2. Expansion of an audit report

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.

9.10. Problem number - 9mperfections in financiai statements

9.10.1. introd Faction

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.

9.10.2. rip efining problem number 9

Problem 9 - The financial statements that are used in order to calculate the Chapter 9 - Identification of problems and recommendations thereto 234

maximum amount available for distribution as dividends, are not perfect.

The constraints of timeliness, problems in achieving a balance between benefits and costs in the preparation of financial statements and problems in achieving a balance between qualitative characteristics, will affect the financial statements of a company. Furthermore, profit in an income statement may be enhanced at the expense of the balance sheet of a company through changes in depreciation policies, the capitalization of interest, selecting a specific policy for. the writing off of goodwill and accounting for brands in a particular way. Other factors such as those discussed in paragraph 4.5., 4.6., 4.7. and 4.8. may create even more problems for the users of financial statements.

9.10.3. Recommendations - wobiem number 9

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).

The importance of the stewardship duties of directors was discussed in paragraph 2.6.2. The stewardship duties of directors have been formalised in South Africa in Chapter 9 - Identification of problems and recommendations thereto 235

The King Report on Corporate Governance which was addressed in paragraph 2.6.6.

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).

The corporate governance principles encompassed in The King Report on Corporate Governance in South Africa include similar principles. The vigilant application of the principles in The King Report of Corporate Governance, should be monitored to prevent some of the problems highlighted in the United Kingdom.

Furthermore, in South Africa, the report on proposed amendments to section 286 (3) of the Act which was discussed in paragraph 9.5.3.1. include a recommendation that a Review Panel be set up. The role of the Review Panel would be to examine, as it judged appropriate, any identified or alleged material departures from accounting standards that, in its view, involved an issue of principle, or which the Review Panel felt might result in the financial statements not achieving fair presentation. The Review Panel will also address gaps or inadequacies in existing accounting standards revealed by financial statements. It is envisaged in the report on proposed amendments to section 286 (3) of the Act that companies should use AC 000 Framework for the preparation and presentation of financial statements when deciding how to account for transactions or events not covered in accounting

standards (SAICA, 1996:19). Chapter 9 - Identification of problems and recommendations thereto 236

9.11. Problem number 10 - The selection of an appropriate dividend policy

9.11.1. Introduction

The selection by a company of an appropriate dividend policy, should take cognisance of the characteristics, advantages and disadvantages of a number of dividend policies which were discussed in paragraph 5.2. Paragraph 5.9. made it clear that the environment in which a company and its stakeholders exist should also be considered in this regard.

9.11.2. Defining problem number 10

Problem 10 - The selection of an appropriate dividend policy should consider a host of factors beyond those directly influencing the company.

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.

.11.3. Fi commendations - problem number 10

The effect of a particular dividend policy on the stakeholder environment of a company should be considered in detail in the South African perspective.

The following are some of the factors that should be considered by directors in their 'choice of a dividend policy:

the payment of dividends denies a company the opportunity of reinvesting

Chapter 9 - Identification of problems and recommendations thereto 237

profits internally. In turn, external sources of financing will have to be sought at a cost; the payment of dividends, based on dividends policies that would indicate a payment irrespective of profit, could increase the risk profile of a company; the payment of cash dividends increases pressure on borrowings or potential borrowings as the cash resources of the company are drained; the lack of cash dividends denies small investors the opportunity of a steady immediately usable income; dividends should be underpinned by current year accounting profit; reasons for changes in dividend policies should be disclosed to investors; the continuous declaration of non-cash dividends could dramatically dilute the shareholding of investors; the payment of non-cash dividends could mislead or confuse small, unsophisticated investors; the payment of scrip dividends denies the fiscus of income from STC that has to be made up from other sources; the payment of cash dividends may facilitate additional share investments that could broaden shareholding, of particularly small individual investors, on the JSE.

Directors should strive to achieve a balance between the needs of shareholders, stakeholders, the population at large and the company.

9.12. Problem number 11 - Reasons f P alternatives to of Ash diva ends

9.1 2.1 . introduction

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

and scrip dividends. Chapter 9 - Identification of problems and recommendations thereto 238

9.12.2. Defining probiem number 11

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.).

9.12.3. Recommendations - probOem number 11`11

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.

Dividend announcements in newspapers, periodicals and letters to shareholders, should disclose the following information in detail: clear, comprehensible reasons for the issuance; clear instructions on the election (if any) that shareholders need to make;

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

Financial statements should include the following information in addition to existing disclosure requirements for dividends: business reasons for the issue of dividends in alternative forms to cash dividends; the current and future liquidity possibilities of particular dividend forms and the effect of alternative forms of dividends on the book value of carrying value on the investment of a shareholder.

9.13. Problem number 12 - Accounting for the payment of capitalization awards

9.13.1. Ontroduction

At the time of the payment of capitalization awards, a transfer of a specific value has to be made to the share capital account of a company from a number of available sources.

9.13.2. Defir ong prob gin number 12

Problem 12 - The payment of capitalization awards may be accounted for at either book value or market value in South Africa.

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.

13.3. Recomm nd tions - problem number 12

The setting of accounting standards in South Africa, is in a transitionary period. Generally accepted accounting practice in South Africa is under review in order to Chapter 9 - Identification of problems and recommendations thereto 240

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, capitalization awards and scrip dividends (which are closely related to capitalization awards) need to be addressed as soon possible as both practices are common in South Africa.

9.14. Problem number 13 - The effect of SIC on dividend payments

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.

9.14.2. Defining problem number 13

Problem 13 - STC has a negative effect on the South African economy.

The use of capitalization awards and scrip dividends as alternative forms of dividends, need not necessarily be seen as problematic. The problem is rather that STC was introduced into the South African tax system in the first place.

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

9.14.3. Recommendations - probiem number 13

The Katz Commission on Taxation in South Africa is currently reviewing STC. Professor Dennis Davis, a commission member, has made it clear that STC has a short life (Klein, 1 996:1).

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. Problem number 14 - Accounting entries at the finalization of e

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.

5.2 ing problem number 14

Problem 14 - A correction to the shareholders for dividends account at the finalization of a DRP, may be accounted for either through either a bonus share approach or a reinvestment approach in South Africa.

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

a reinvestment approach which were discussed in paragraph 8.8.4.1. and 8.8.4.2.

9.15.3. Recommendations - probiem numbev 14

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.

KEASEY, K & WRIGHT, M 1993: Issues in Corporate Accountability and Governance: An Editorial. Accounting' and Business Research, Volume 23 Number 91A Corporate Governance Special Issue 1993: 291-303.

KLEIN, M 1996: Dividend levy still a menace. Sunday Times Business Times, March 17 1 996: 1.

KPMG, 1995: Toolkit for the Company Director. Johannesburg: KPMG.

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.

THE JOHANNESBURG STOCK EXCHANGE 1994: Report of the research sub-committee on the future structure of the Johannesburg Stock Exchange to the Johannesburg Stock Exchange Committee. Johannesburg: The Johannesburg Stock Exchange. Chapter 9 - Identification of problems and recommendations thereto 244

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1983a: AC 100 Preface to statements of generally accepted accounting practice. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1983b: AC 202 Accounting for fixed asset revaluations. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1985: AC 103 Extraordinary items and prior year adjustments. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1990: AC 000 Framework for the preparation and presentation of financial statements. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1994: AC 123 Property, plant and equipment. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1995: AC 103 Net profit or loss for the period, fundamental errors and changes in accounting policies. Johannesburg: SAICA.

THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1996: Proposed amendments to the Companies Act, 1973 on legal backing to accounting standards. Johannesburg: SAICA.

TOFFLER, A 1971: Future Shock. London: Pan Books Ltd. Summary 245

CH PTE 10 -SUM ARY

"Never try to tell everything you know. It may take too short a time." - Norman Ford (Peter, 1977:281).

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.

10.2. The position of this study in the South African context

10.2.1. The state of the South African economy

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.

10.2.2. Democvatizing equity

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).

10.2.3. Empioyee sh ve incentive schemes

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.

10.2.4. individu buying power

This study of dividends, focused on a number of problems that may be encountered by small individual investors and in particular black investors who intend to invest on the JSE. Paragraph 7.4.6.1. highlighted a number of problems that these investors face and noted that their discretionary savings may be limited. In South Africa, more than 50% of the black population earns less than R300 a month (Nyhonyha & Braithwaite, 1996:8). The savings of potential investors as individuals, however, need not be mobilized.

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

The receipt of dividends by investors, is only one of the benefits of an economy. Although dividend rules and accounting issues relating to the payment of dividends May be clouded by other issues, dividends can provide much more than an income for investors. The careful treatment of dividends will eventually assist in the success of the fledgling South African democracy and economy.

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.

10.3. New research topics

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.

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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.

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