IFRSs set down requirements for the measurement and recognition of profits, but if a UK company wishes to pay dividends out of those profits its directors must consider whether those profits are distributable. Our practical issue this quarter considers the concept of distributable profits in the context of some of the more complex areas of IFRS accounting.
An item that can significantly affect a company's distributable profits is a defined benefit pension scheme. This quarter's topic of focus deals with a recent exposure draft (ED) produced by the International Accounting Standards Board (IASB) which proposes a number of amendments to the required accounting for such schemes.
The IASB and US Financial Accounting Standards Board (FASB) have recently announced a modified strategy for the convergence of IFRS and US GAAP, focusing on projects viewed as a priority. Subsequent to this, a modified work programme for IFRSs was released and is reflected in the ASB and IASB timetables section of this publication. Significantly, the project to replace all aspects of IAS 39 on financial instruments is now expected to be completed in the second quarter of 2011 and the project on derecognition is to proceed with a more limited scope.
One person who will not be involved in these future developments, but has been central to the development of financial reporting both in the UK and around the world, is Ken Wild – the recently retired head of Deloitte's Global IFRS Leadership Team and our interviewee this quarter.
Practical issue: Distributable profits
It goes without saying that a company's primary aim is to make profits. However, in the UK there is another consideration if a company wishes to transfer benefits to its shareholders – are those profits distributable?
The determination of distributable profits is a complex area, operating at the interface between accounting and company law and demanding an appreciation of both. This article aims to summarise briefly the key considerations for directors and their application to IFRS accounting.
As distributions are made by companies, a group's consolidated reserves position is irrelevant to its ability to pay dividends.
UK law dictates that a limited company may make a distribution only out of profits available for that purpose. Those are the accumulated realised profits less accumulated realised losses shown in the company's relevant accounts. Distributions by public companies are further restricted as such companies cannot make a distribution if by so doing its net assets would fall below the aggregate of its called-up share capital and undistributable reserves.
For the purposes of the law on distributions, a public company is any company designated as a plc whether or not its shares are traded on a market.
These terms are discussed below.
The most obvious form of distribution is a company's annual dividend paid in cash. However, the term applies much more widely, encompassing any distribution of a company's assets to its members. This wider definition might often be significant to transactions within a group of companies, such as:
- the waiver of a liability due from a parent to its subsidiary;
- the transfer of tax losses for no consideration; or
- the transfer of a property for below its market value.
It is therefore important that directors are mindful of their distributable profits position whenever they are contemplating a transaction which could constitute a transfer of value from a subsidiary to its parent.
Profits are treated as realised when they arise in the form of cash or another form of 'qualifying consideration'.
Qualifying consideration comprises:
(a) cash; or
(b) an asset that is readily convertible to cash; or
(c) the release, or the settlement or assumption by another party, of all or part of a liability of the company, unless:
(i) the liability arose from the purchase of an asset that does not meet the definition of qualifying consideration and has not been disposed of for qualifying consideration; and
(ii) the purchase and release are part of a group or series of transactions or arrangements that fall within paragraph 3.5 of this guidance; or
(d) an amount receivable in any of the above forms of consideration where:
(i) the debtor is capable of settling the receivable within a reasonable period of time; and
(ii) there is a reasonable certainty that the debtor will be capable of settling when called upon to do so; and
(iii) there is an expectation that the receivable will be settled.
Tech 01/09 Guidance on the determination of realised profits and losses in the context of distributions under the Companies Act 2006.
Again, transactions within a group might often need careful consideration. For example, when a transaction results in recognition of a receivable from another group company it is necessary to consider whether the other company is capable of settling the balance and intends to do so.
The concept of qualifying consideration does not apply to losses. Losses are treated as realised unless the law, accounting standards or relevant technical guidance provide otherwise. This apparent discrepancy is an intentional result of the company law principle of providing protection for a company's creditors.
A company is required to determine whether it has sufficient distributable profits to make a distribution based on its relevant accounts. A company's last set of statutory accounts may be used for this purpose, but if they do not show sufficient distributable profits interim accounts must be prepared. Interim accounts for these purposes do not have to be in the same format as statutory accounts, indeed management accounts may be used provided they deal with all relevant matters (for example, a company's tax balances may need more consideration than would be the case for a normal set of monthly management accounts).
Again, public companies are subject to more stringent requirements. Their interim accounts for the purposes of determining the legality of a distribution must be filed with Companies House prior to the distribution and must be drawn up broadly in accordance with the requirements for annual accounts.
Application of IFRS accounting
When the requirements on distributions were enshrined in the Companies Act 1985, the use of historical cost accounting and the overriding principle of prudence meant that profits recognised in a company's accounts were most probably realised. The advent of IFRSs, with their increased focus on fair values, has meant that this is no longer the case.
In response to this, the Institute of Chartered Accountants in England and Wales (ICAEW) and Institute of Chartered Accountants of Scotland (ICAS) have issued guidance in this area, most recently Tech 01/09 Guidance on the determination of realised profits and losses in the context of distributions under the Companies Act 2006 and Tech 03/09 Proposed additional guidance on the determination of realised profits and losses in the context of distributions under the Companies Act 2006. Some of the more common areas which can cause difficulties are discussed below.
Share-based payment expenses
IFRS 2 Share-based payments requires an expense to be recognised in profit or loss in respect of equity-settled share based payment transactions, with a corresponding credit in equity. The expense is a realised loss. However the credit to equity is frequently considered distributable, meaning there is no net reduction in distributable profits. This is the case so long as:
- the goods or services reflected in the IFRS 2 expense do not, as a matter of law, constitute consideration for the issue of shares; and
- the expense is included in profit or loss (i.e. it has not been capitalised as part of a tangible or intangible asset).
Employee share schemes will often meet these conditions but share-based payment transactions with other suppliers may not.
The position for cash-settled share-based payment transactions is straightforward, as the expense recognised represents an accrual for cash payment and is therefore a realised loss.
Defined benefit retirement benefit schemes
A defined benefit balance results from a number of gains and losses (service costs, interest cost, actuarial gains and losses etc) and cash transactions (contributions paid by the company and benefits paid to members). Only the gains and losses are relevant to a company's distributable profits position.
The impact on distributable profits is determined by the cumulative net gain or loss recognised in reserves in respect of a scheme (including the gain or loss recognised in profit or loss and any gain or loss in other comprehensive income).
- if a net debit to reserves has been recognised, this is a realised loss and there is no difference between the accounting balance and realised profits; and
- if a net credit has been recognised, this is realised only to the extent that it has been agreed by the scheme's trustees that a refund will be paid in qualifying consideration.
This is an example of the principle that losses are assumed to be realised whilst profits are not. A company's realised profits position with respect to a defined benefit scheme cannot be better than its accounting position, but it can be worse.
Fair value measurement
IFRSs require or allow various items to be measured at fair value. As a general principle, fair value gains are realised where they are readily convertible into cash, and as a result:
- profits on remeasurement of a financial asset traded in an active market would be expected to be realised; and
- revaluation gains on investment properties would not be realised.
The status of other fair value gains might be less clear and will require consideration on a case by case basis.
As is often the case, fair value losses are more likely to be considered realised than profits. In fact, such losses are only unrealised where:
- profits on remeasurement of the same asset and liability would be unrealised; and
- the losses would not have been recorded if fair value accounting not been applied.
Thus, to consider a fair value loss on an asset to be unrealised, it is necessary to demonstrate both that the asset is not readily convertible to cash and that if the asset were measured at cost it would not be impaired.
Hedge accounting From a distributable profits point of view, it is necessary to consider the combined effect of both sides of a hedge relationship to determine whether there is a realised profit or loss.
The application of this to hedging under IAS 39 Financial Instruments: Recognition and Measurement is summarised below:
Where a business combination is completed by the purchase of a subsidiary, the accounting required by IFRS 3 Business Combinations will most likely have no impact on distributable profits as the accounting will exist only at a consolidated level. Where trade and assets are acquired, the accounting may impact individual company accounts.
IFRS 3(2008) requires a gain to be recognised on acquisition in a number of circumstances (for example, on a bargain purchase or on settlement of a pre-existing relationship between the acquirer and the acquired entity). Careful consideration will be needed before concluding that any such profit is realised as it is unlikely that qualifying consideration will be received upon completion of a business combination.
Reduction of capital by solvency statement
One means of improving a company's distributable profits position is by reducing its capital (effectively converting share capital into distributable reserves). Under Companies Act 1985, such a reduction required court approval but since October 2008 a simpler method has been available.
A reduction of capital may now be affected by special members' resolution supported by a solvency statement signed by each of the company's directors. The solvency statement and special resolution must then be filed with the Registrar of Companies together with a statement of capital setting out the details of the reduced share capital of the company and a statement by the directors confirming that the solvency statement was made not more than 15 days before the passing of the special resolution.
The resolution to reduce the company's share capital then takes effect on registration by the Registrar.
The above is, of course, only an indication of the many issues which may need to be considered in determining whether a company has sufficient distributable reserves to make a distribution. Companies should consult with their advisers if they are in any doubt about this matter.
Further guidance on distributable profits can be found in the Deloitte publication iGAAP 2010: IFRS Reporting in the UK.
A coffee with ... Ken Wild
Ken Wild was a partner at Deloitte for 26 years until his retirement in 2010, for much of that time he led the firm's UK technical department and, more recently, the Global IFRS Leadership Team. Ken was also a member of the ASB from 1994 to 2003 and IFRIC from 2003 to 2009.
What do you see as the opportunities and risks facing standard setters in the coming years?
The opportunity is to achieve genuinely global standards and thus a common language of accounting. A common language does not mean complete uniformity because even a common language will have different accents, I think you will always be able to recognise a French, a German or an American set of accounts because they will look slightly different. What we have got to avoid is dialects. Dialects being, in accounting standard terms, words having different meanings for different people.
So I think that the opportunity is we will move to a common global set of standards. The risk is that it is such a vast task and when you consider bringing in, say, the Americans the difficulties become clear. The Americans have a really difficult task going from a very detailed set of rules to a less detailed set of rules, so there is real difficulty as we bring some people in.
I think the other main risk is politics and politicians interfering, trying to use accounting standards for regulatory, or tax reasons or whatever and interfering with the thing. Politicians will add layers which will potentially add complexity or may actually distort what we see as real numbers.
An example is the debate around impairment of loans where you ought to be telling the market where you have got to, what's happened with the loans you have made. What you shouldn't do is provide for loans you haven't even yet made on the basis that the economic cycle will turn down and when it does you'll make a load of losses. If you make a load of losses in the future, you make a load of losses in the future, you should not start distorting the accounting, telling people that you've made losses now for smoothing reasons or whatever and that I think is the big danger. The politicians may be acting either for straight political reasons or what they see as good reasons, but reasons that are actually distorting the purpose of accounting which is communicating what has happened to the company.
Will standards be simpler or more complex in ten years time?
I would like to think things can get simpler, but the world tends to make things more complex until you get to a point where they are so complex, somebody says too much and you do a complete rejig. I think that is further away than ten years.
What do you see as the IASB's greatest strength and its biggest weakness?
I think its greatest strength is the strength of will behind making it happen. I think they have some really good people involved and there is a genuine desire to do the job well.
The strength of all these different people from different cultures being involved is also its biggest weakness. The difficulty comes because people from different cultures have a different view of how to write standards. A group of British people will write a standard in a British way. If you put American, French, German, Japanese and British people together writing in different ways, they are tearing in different directions. The danger is that you say, let's just stop and go back to the theory and you forget about communication and start basing it too much on theory. This actually gets in the way of good communication, and accounting is all about good communication.
For example, we seem to be moving towards using exit values much more, whether for assets or for liabilities. Exit value makes enormous sense for some things. A lot of financial instruments, for example, are held for their resale value. But consider office or computer equipment; its exit value may be minimal, nobody wants the second hand equipment, but it's very valuable to you and would cost a lot if you had to replace it. You may want to put a fair value on those things, but exit value would be pretty meaningless.
Or take the example of properties. If you've owned a property for sixty years, its original cost may be pretty meaningless, so you want to revalue it. But why are you revaluing it? Is it because of what you could sell it for or what it would cost you to replace it? So I would say exit value is a good theory, but it may not work for everything.
Are there any major areas where we have no accounting standard yet, but we might in the future, or areas where we might see big changes?
I can think of quite a few I would like to do away with. Deferred tax, get rid of that one, earnings per share, get rid of that one. Unless we get into industry specific standards, I can't honestly think of anywhere we really want to have another standard.
Perhaps we ought to have a standard on liabilities because we haven't actually got one, we have standards covering particular types of liability. We're messing around with IAS 37 and getting it very wrong, but we ought to have an actual liability standard. What I was saying earlier about exit value equally applies to liabilities because that's essentially what they've sought to do with IAS 37. If I wanted somehow to remove completely this liability, what would I have to pay now? For something like litigation, the money you would have to pay now may be a million miles from what you actually intend to do.
What we are doing with things like associates and hedge accounting still needs quite a lot of work. The standards are there but it's a case of harmonising and improving.
What has been the most rewarding and the most challenging experience of your career?
The most rewarding is easy. I've come across so many people that are so good at what they do and so many people that I have really liked and enjoyed working with and have been intellectually stimulating.
Within a firm and a department like ours, we have a fantastic team of people and the banter that goes on is really enjoyable and rewarding. Outside the firm, some of the groups, such as working on the old accounting standards board were very much like that. It's interesting that the proceedings of those groups were not on public record. Whether it alters things when you put them on public record I don't know, but I have always thought the old ASB did a fantastically good job and was a very enjoyable thing to be involved in. I got a lot out of my involvement in public sector accounting because it was sort of nowhere, basically cash accounting and so archaic, and we've now moved to a decent form of accounting.
The issues in the public sector are fascinating. We all know what impairment of an asset is, it's when you are not going to get your money back. But when a government buys an aircraft carrier it doesn't actually get very much money back from it – so impairment must mean something different. You are trying to get to the same basic concept, you have got something you wish you hadn't paid that much for and it's not worth that much to you. There is no money that you are going to get back for it so you have to find another way.
Were there any turning points which changed the course of your career?
When I was at university, I always said there were three things I would never do: be an actuary because it was boring, be a teacher because I didn't have any patience for it and be an accountant because it was even more boring. I wanted to be an academic at university but I hadn't found the post, I needed a job in York and KPMG happened to have a York office and were advertising for people. I thought I would stick with it for a year until I found a proper job – literally that was how I got into accountancy. I then found I enjoyed it.
The next pivotal point was when I was six months qualified and the Accounting Standards Committee advertised for staff members. They were looking for people who were three years qualified and I thought, "that sounds interesting, but maybe in another few years" and my wife said to me: "well you're not going to lose anything by applying." I applied and I got the job and had a couple of years there. I was intending to stay longer but Deloitte advertised for people for a technical post. It was so unusual to see adverts for the technical department that I thought I might as well talk to them as I hadn't done an interview for a couple of years and it's always good to keep your hand in; so I came to Deloitte.
At the time Deloitte was thought of as a bit American and a bit brash; it was the smallest of the firms. I wasn't sure it was where I wanted to be but I found the people really friendly. When I was made a partner, I was just amazed how you were welcomed in; you became part of something that was very important to the individuals involved.
There are lots of other points when I was at the ASB, which became very significant to me. There are various things I suppose that were issues that I took very much for my own. For example, I thought we were getting to a stage that accounting standards were catering for large companies. The average small practitioner was producing a set of accounts for a small company that their bank manager wouldn't be able to understand and the practitioner would say to the company: "don't bother about these, we have got to produce them, got to sign them, got to file them, but you won't recognise your business in them."
I said we ought to do something for small companies and did a lot of campaigning, eventually convincing David Tweedie so he agreed to let me chair a working party. That was the origin of the FRSSE. Equally there was a working party some years later that I was asked to chair. I was chairing the technical committee at the industry and they asked if I would chair a committee on window dressing, which had become a bit of a cause célèbre. I said I would but I thought that the up and coming issue was off balance sheet finance. This then absolutely blew up. We produced a technical paper from the institute which eventually lead into FRS 5.
These became big issues that I was heavily involved in.
What will you miss most about Deloitte, and least?
100% I'll miss the people most. Deloitte has good people, not only in my department – who I obviously know best – but spread across the firm. I also think what I do makes a contribution, both to the firm and more widely. I enjoy it and I think it is interesting, so I will miss the work as well; but it's the people I will miss most.
I am really looking forward to being in control of my own time. I have always felt it is in the nature of what I do that I have to be available 24 hours a day. I never mind when people phone me up in the middle of the night because they are in the office working and I am at least at home, but it will be quite nice not to be subject to that, not to feel responsible.
Topic of focus: Proposed amendments to accounting for defined benefit plans
Accounting for defined benefit plans has long been recognised as one of the more complex and controversial areas of financial reporting. It is also an area in which IFRSs include an unusual amount of optionality, both in the timing of recognition of gains and losses relating to such plans and in their presentation in the statement of comprehensive income.
The IASB's recent exposure draft (ED) Defined Benefit Plans – Proposed amendments to IAS 19 seeks to address the following perceived deficiencies in the current standard:
- companies do not have to account for changes in their defined benefit plan immediately, with the so called 'corridor approach' allowing deferral of some actuarial gains and losses;
- there is little comparability in presentation of amounts relating to defined benefit plans, with actuarial gains and losses recognised either in profit or loss or in other comprehensive income (OCI), but with limited guidance on the presentation of other items within the income statement; and
- there are voluminous disclosure requirements in this area, but these may not always highlight the risks arising from defined benefit plans.
The IASB seeks to address these issues through the ED by standardising the recognition and presentation of gains and losses relating to defined benefit schemes and by introducing new disclosures focussing on risks.
The ED does not address the measurement of defined benefit plans (i.e. the projected unit credit method and the actuarial assumptions inherent in its use) or the accounting for defined contribution schemes. The IASB will consider after 2011 whether to address these topics.
Recognition of actuarial gains and losses
The so called 'corridor method' of deferring a portion of actuarial gains and losses falling outside a specific range (being the greater of 10% of the defined benefit obligation and 10% of the fair value of plan assets) has long been something of an anomaly in IFRSs in allowing some gains and losses not to be recognised at the point they arise. Certain gains and losses (for example, the effective portion of cash flow hedges and revaluation gains on items of property, plant and equipment) are recognised outside profit or loss, but the corridor method of disclosing gains and losses in full but spreading their recognition over a number of years is unique to defined benefit plan accounting.
The ED's proposal to remove this option is intended both to make it easier to understand defined benefit balances and to improve comparability between companies.
Comparison with current UK practice under IAS 19
The corridor approach is employed only by a minority of UK companies in accounting for defined benefit plans. Therefore, this element of the ED (while it is very significant for those entities using the corridor approach) might have less impact on financial reporting in the UK than in other territories where use of the corridor is more widespread.
Presentation of gains and losses
The current version of IAS 19 also offers a choice in the presentation of actuarial gains and losses, meaning that some companies present these, often significant, movements within profit or loss while others present these as items of other comprehensive income.
In addition, IAS 19 does not prescribe the presentation of the various other gains and losses recognised within profit or loss (current service cost, interest cost, expected return on plan assets, curtailment gains etc), which leads to additional variation in practice and lack of comparability between different sets of financial statements.
The ED proposes a simpler, but much more prescriptive approach, classifying all gains and losses into one of three categories and prescribing the presentation of each:
Comparison with current UK practice under IAS 19
The approach suggested by the ED is, on the face of it, similar to that prescribed by FRS 17 (with actuarial gains and losses recognised outside profit or loss and a split between operating and finance elements of costs within profit or loss) and applied by many UK companies in their IFRS reporting.
There are, however, significant differences in the apportionment of gains and losses between the three categories, most notably:
- finance costs in profit or loss are a function of only the net plan surplus or deficit and the time value of money, the concept of expected returns on plan assets is eliminated, actual returns go into OCI;
- settlement gains and losses will be recognised in OCI, not as part of the employee expense in profit or loss; and
- all changes arising from the limitation on recognition of assets for plans in surplus will be recognised in OCI, rather than following actuarial gains and losses to either OCI or profit or loss.
Thus, the ED proposes a split which is superficially similar to the approach currently employed by many UK companies but there may be significant differences in calculated the three items.
In the ED, the IASB attempts to respond to criticism that the requirements of IAS 19 result in disclosures which are of excessive length but which neither aid an understanding of the affect of defined benefit plans on the financial statements as a whole, nor highlight information about the risks arising from such plans.
The ED's revisions to disclosure requirements are thus intended to satisfy the following objectives:
- explanation of the characteristics of an entity's defined benefit plans;
- identification and explanation of the amounts in the financial statements resulting from those plans; and
- description of how future cash flows may be affected by defined benefit plans.
The removal of the option of the 'corridor method' naturally leads to a reduction in the number of disclosure requirements, as this is an option that currently requires a high level of disclosure.
The ED proposals also include requirements to disclose:
- further quantitative information on actuarial assumptions, including:
- separate disclosure of actuarial gains and losses arising from changes in demographic and financial assumptions;
- sensitivity analyses about actuarial assumptions; and
- the present value of the defined benefit obligation adjusted to exclude the effect of projected growth in salaries;
- further narrative information on risks associated with defined benefit plans and the investment strategy for plan assets, including factors that could cause contributions over the next five years to differ from current service costs.
Comparison with current UK practice under IAS 19
Many UK companies have taken note of the ASB's voluntary reporting statement Retirement Benefits – Disclosures and make disclosures in excess of the minimum requirements of IAS 19. In particular, disclosing an analysis of the sensitivity of the defined benefit obligations balance to changes in actuarial assumptions.
However, the proposed disclosures, for example, disaggregation of actuarial gains and losses and adjustment for the effect of projected growth in salaries, go beyond the suggestions of the ASB statement.
Other proposed changes
The ED includes other proposed changes, intended to add clarity in a number of areas.
Classification of employee benefits
The ED proposes the removal of the distinction between 'post employment benefits' and 'other long-term employee benefits', meaning that all long-term defined benefit arrangements would be recognised, measured and disclosed in a consistent manner as described above. Thus, for benefits such as long-term profit sharing or bonus arrangements and long-term disability benefits some elements of actuarial gains and losses are proposed to be taken to OCI.
The ED specifies that only costs relating to the management of plan assets would be presented as a reduction in the return on plan assets (and, therefore, within the 'remeasurement' category in OCI). Future administration costs relating to the administration of benefits would be included in the measurement of the defined benefit obligation.
The next steps
Comments are invited on the ED by 6 September 2010 and following consideration of comments received the IASB expects to finalise amendments to IAS 19 by June 2011 with an effective date no earlier than 1 January 2013.
As noted above, several of the proposals might be expected to have less impact in the UK than in some other territories, but they will still have significant implications for the presentation and disclosure of defined benefit plans, and perhaps other long-term employee benefits, some of which may require additional involvement of a scheme's actuaries.
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