Computation of net profits u/s 198 of companies act 2013

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Ruchie Khanna (Querist)
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09 January 2017 Dear Experts,

Section 196 of the Companies Act, 2013 ("Act") provides the limits of remuneration that can be paid by the Company. The same has been linked with the Net profits (Profit before tax) of the Company calculated in the manner prescribed under section 198 of the Act.
I am aware of the format and limits for calculating the Net Profits u/s. 198. However i wish to understand the logic behind of the same.
For eg: The reasoning as to why profits from exceptional items are reduced and losses therefrom added back in the said calculation.

Knowing the background of the same would help in understanding how to calculate the NP in different scenarios i.e. when one-off accounting effects are provided in the financials for eg: profits/losses from discontinuing businesses, reserves created as a result corporate restructurings, demergers, slump sales, IND-AS adjustments etc.

Experts vews are solicited!!

Aashok Kumar Sharma

Aashok Kumar Sharma (Expert)
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20 July 2024 The computation of Net Profits under Section 198 of the Companies Act, 2013 is crucial for determining various limits and requirements within the Act, including the maximum managerial remuneration that can be paid. Let's delve into the logic and components involved in this calculation:

### Components of Net Profits under Section 198

1. **Profit Before Tax**: This is the starting point for computing Net Profits. It includes all operating profits, interest income, and other income before deducting tax expenses.

2. **Adjustments for Exceptional Items**:
- **Exceptional Gains**: These are one-time gains that are not part of regular business operations, such as gains from the sale of assets, windfall gains, or gains from legal settlements. These gains are typically excluded from Net Profits because they do not represent sustainable earnings from ongoing business operations.
- **Exceptional Losses**: Conversely, exceptional losses are one-time losses that are not expected to recur regularly. Examples include losses from discontinued operations, impairment losses on assets, or losses arising from legal claims. These losses are added back to Net Profits because they are considered non-recurring and do not reflect ongoing operational performance.

3. **Adjustments for Ind-AS and Other Accounting Adjustments**:
- **Ind-AS Adjustments**: If the company follows Indian Accounting Standards (Ind-AS), adjustments may be required to reconcile Net Profits as per Ind-AS with Net Profits as per the Companies Act. These adjustments ensure consistency and compliance with statutory requirements.
- **Other Accounting Adjustments**: Any other significant accounting adjustments, such as adjustments related to corporate restructurings, demergers, or slump sales, may also impact the calculation of Net Profits. These adjustments aim to reflect the true economic reality of the company's financial position.

### Logic Behind Adjustments

- **Normalization of Earnings**: The adjustments for exceptional items aim to normalize earnings by excluding or adding back non-recurring gains or losses that distort the true operational performance of the company.

- **Consistency and Comparability**: By excluding exceptional gains and adding back exceptional losses, the calculation provides a consistent basis for comparing the company's financial performance across different periods. It ensures that the remuneration limits under Section 196 are based on sustainable, ongoing profits rather than temporary fluctuations.

- **Transparency and Compliance**: These adjustments enhance transparency in financial reporting by clearly delineating between regular operational profits and one-time gains or losses. This is essential for complying with regulatory requirements and providing stakeholders with a clear view of the company's financial health.

### Conclusion

Understanding the rationale behind the adjustments in the computation of Net Profits under Section 198 allows companies to apply the calculation correctly in various scenarios. It ensures compliance with the Companies Act, facilitates accurate determination of managerial remuneration limits, and provides stakeholders with reliable financial information. For specific scenarios involving complex accounting effects like corporate restructurings or Ind-AS adjustments, consulting with a qualified accountant or financial advisor is advisable to ensure accurate computation and compliance with regulatory standards.

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