Study Notes: Computation of Net Profit of a Company (Sec 198 of the Companies Act, 2013)
Introduction
Section 198 of the Companies Act, 2013, is crucial for corporations as it establishes the method for computing net profit. This section is closely knit with section 135 of the act. Section 135 of the Companies Act, 2013, requires specific categories of companies to engage in Corporate Social Responsibility (CSR). The objective is to guarantee that these companies contribute to the welfare of society, the environment, and the economy. Section 135 talks about the expenditure by a company on its Corporate Social Responsibility, the Board of every company referred to in sub-section (1), shall ensure that the company spends, in every financial year, at least two per cent. of the average net profits of the company made during the three immediately preceding financial years, in pursuance of its Corporate Social Responsibility Policy:[1]
A company is required to spend, in a financial year, at least two percent of its average net profits. Section 198 of the act allows us to calculate the net profits of a company.
Section 198 of the Companies Act, 2013 holds significant importance for corporations as it outlines the method for computing profit. This section has a dual application:
1. Corporate Social Responsibility (CSR) under Section 135 of the Companies Act, 2013.
2. Managerial Remuneration under Section 197 of the Companies Act, 2013.
However, accurately determining the exact amount of profits earned can sometimes be challenging.
Section 198 of the Companies Act, 2013 outlines the method for determining the net profits of a company for any financial year, as required by Section 197. Section 198 also addresses the inclusion of governmental benefits like bounties and subsidies in financial computations. It emphasizes that unless the Central Government issues specific instructions to the contrary, these financial aids should be considered as part of the overall calculation. This rule ensures transparency and consistency in how financial figures are reported or assessed, particularly in contexts where governmental support significantly impacts financial outcomes.[2]
The section also enumerates the amounts for which credit should not be acknowledged when calculating the net profit.[3] Profits derived from premiums on shares are generally subject to certain rules or restrictions. However, it exempts companies classified specifically as investment companies under the mentioned clause. This distinction is crucial as it differentiates how such profits are treated based on the company’s categorization, ensuring appropriate regulatory compliance and financial reporting accuracy. When a company forfeits shares (typically due to non-payment by shareholders), it may later sell these forfeited shares. Any profit made from such sales. The sub-section (4) provides, when a company sells immovable property or fixed assets that are part of its operations, any resulting profits are usually categorized as capital gains. This categorization holds true unless the company’s core business activity is buying and selling such assets, in which case these profits could be treated differently, possibly as ordinary revenue. The distinction is important for financial reporting and tax purposes, ensuring that the appropriate rules and regulations are followed based on the nature of the company’s business operations.
Section 198(5) also specifies the amounts that should be deducted or not deducted, in the calculation of the net profit.
Meaning
The essence of Section 198 can be traced back to the Companies Act of 1956, where Sections 349 and 350 laid the groundwork for its current provision. This legislative continuity underscores a consistent policy objective: tying managerial remuneration in Indian companies to tangible business performance.
Section 198, by delineating a specific method for calculating net profit tailored to managerial compensation, further advances the principles established in the 1956 Act. This approach aims to prevent potential abuses such as inflated compensation packages driven by non-operational income sources like asset sales or investment gains.
Fundamentally, Section 198 underscores a longstanding legislative commitment to promoting responsible compensation practices within Indian corporate governance. It ensures that managerial remuneration accurately reflects the company’s operational success, thus fostering a more sustainable and accountable business environment. In paragraph 13.8, the J.J. Irani Committee[4] said that While the Committee has advocated for shareholder determination of managerial remuneration as a separate recommendation, it also expressed the view that the prevailing method of computing net profits for managerial remuneration, as outlined in Sections 349 and 350 of the Act, should be abolished. The Committee’s rationale behind this stance is that the existing provisions of the Companies Act already sufficiently guarantee the presentation of an accurate and transparent depiction of the company’s profits.
Usage
Section 198 of the Indian Companies Act, 2013 plays a pivotal role in upholding robust corporate governance standards by delineating a precise approach for computing a company’s net profit
1. Managerial Remuneration Determination
Section 198 introduces a methodology distinct from conventional accounting practices. By excluding specific non-operational income and expenses, it offers a more accurate portrayal of a company’s fundamental business performance. This adjusted net profit figure serves as the basis for determining managerial compensation, discouraging profit manipulation solely to justify inflated remuneration packages. Consequently, Section 198 promotes a closer alignment between managerial rewards and the company’s genuine operational achievements.
2. Minimum CSR Spending Threshold
In accordance with statutory requirements, Indian companies are obligated to allocate a portion of their profits towards Corporate Social Responsibility (CSR) endeavors. Section 198 defines the calculation of net profit used to establish the minimum amount earmarked for CSR activities. By filtering out non-core income fluctuations, this methodology ensures a stable foundation for CSR budgeting, facilitating long-term planning and consistent implementation of social responsibility initiatives.
3. Enhancing Transparency and Stakeholder Confidence
The standardized computation method mandated by Section 198 enhances transparency for stakeholders. Shareholders can trust that managerial compensation is directly tied to the company’s core performance, while the methodology for determining CSR expenditure becomes transparent and consistent. This transparency bolsters corporate governance by fostering trust and accountability within the organization.
Companies Amendment Act, 2017
The Ministry of Corporate Affairs implemented the Companies (Amendment) Act, 2017, on January 3, 2018. This amendment act aimed primarily at streamlining the compliance process and eliminating redundant procedures. Its objectives included reducing regulatory intervention, fostering self-regulation among companies, enhancing clarity in the provisions of the act, supporting the growth of startups, and reinforcing corporate governance standards. In line with the suggestions from the Company Law Committee, 2016 (CLC 2016), and the Standing Committee on Finance, the 2017 Amendment to the Companies Act dismantled the stringent controls previously imposed on managerial remuneration under Section 197 and Schedule V. One significant change brought about by the 2017 Amendment was the removal of the requirement to seek Central Government approval for remuneration payments exceeding the prescribed thresholds.
Following the 2017 Amendment, a company can now compensate its managers with remuneration surpassing the previously set thresholds, provided it obtains shareholder approval via a special resolution. This amendment marks a significant departure from the stringent controls on managerial remuneration that had been in place in India for 61 years. It signifies a fundamental shift in the government’s policy, aimed at making India a more appealing business destination and enhancing the ease of doing business by eliminating unnecessary regulations.
Relevance of Section 198
The Ministry of Corporate Affairs (MCA) has officially notified Indian Accounting Standards under Section 133 of the 2013 Act. The Indian Accounting Standards are in consistency with the International Financial Reporting Standards (IFRS), provide comprehensive guidelines covering all facets of accounting, including the computation of “net profits.”
Given the robust framework provided by the Indian Accounting Standards, which aim to maintain consistency and transparency in financial reporting, there are sufficient safeguards in place to prevent the artificial inflation or inaccurate reporting of profits. Indian Accounting Standards (Ind ASs) are regulations specified in accordance with Section 133 of the Companies Act, 2013. Material omissions or errors in financial items are considered significant if they have the potential, either individually or together, to impact the economic decisions made by users based on the financial statements.[5] Therefore, even in the absence of Section 198 of the 2013 Act, the adherence to these accounting standards ensures that companies maintain integrity and accuracy in their financial disclosures. The Companies (Appointment and Remuneration of Managerial Personnel) Rules, 2014[6] also provides that the paid-up share capital, turnover, or outstanding loans or borrowings as the case may be, existing on the last date of latest audited financial statement shall be taken into account.
The Indian Accounting Standards along with the The Companies (Appointment and Remuneration of Managerial Personnel) Rules, 2014 already account for all the methodology and aspects of the accounting of net profits. Due to the prevalence and the value of the Indian Accounting Standards, a requirement of section 198 does not seem to arise.
Conclusion
The relaxation of managerial remuneration controls and the implementation of Indian Accounting Standards (Ind AS) under Section 133 of the Companies Act, 2013, raise questions about the continued relevance of Section 198. This aligns with the perspective expressed by the Irani Committee in 2005, which argued that similar provisions in the Companies Act, 1956 (Sections 349 and 350) were no longer necessary due to the presence of adequate safeguards to ensure the faithful presentation of a company’s financial performance.
[1] The Companies Act, 2013, s. 135(5).
[2] Id, s. 198(2).
[3] Id, s. 198(3).
[4] Report of the J.J. Irani Expert Committee on Company Law, submitted on May 31, 2005, at Para 13.8.
[5] https://www.mca.gov.in/content/mca/global/en/home.html
[6] MINISTRY OF CORPORATE AFFAIRS NOTIFICATION New Delhi, the 31st March, 2014
