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Following the introduction of IFRS and IFRSbased UK
standards, revised and expanded guidance has recently been issued
on distributable profits.
UK legislation only permits companies to pay dividends out of
profits available for distribution, i.e. those that are realised
profits, in accordance with generally accepted accounting
principles. In the past, the majority of companies were able to
determine their available levels of distributable profit, simply by
referring to the balance on their profit and loss account
reserve.
However, as accounting standards have become more complex, the
question of whether or not profits are realised seems to be more
and more contentious. Because the concept of realised profits is a
legal one, accounting standards do not address the impact their
provisions may have in an area that is very important to companies.
Guidance is, however, produced by the professional institutes. As a
consequence of the introduction of IFRS and IFRSbased UK standards,
the Institute of Chartered Accountants in England and Wales and the
Institute of Chartered Accountants of Scotland have recently issued
joint revised and expanded guidance – TECH 02/07
'Distributable profits: implications of recent accounting
changes'.
Probably the most significant issue raised by IFRS and UK
standards based on IFRS, is the increased use of fair values. The
guidance focuses on, but is not limited to, considering how
movements in fair values impact the levels of distributable
profits.
While the law on profits available for distribution under the
Companies Act 2006 has not changed, the technical release
effectively alters the definition of what constitutes a realised
profit. The general principle is that profits will be considered to
be realised to the extent that they either relate to a transaction
settled in cash, or to items that are readily convertible to
cash.
Many companies not applying IFRS and which do not have
particularly complicated accounts might be forgiven for thinking
that TECH 02/07 will not have any ramifications for them. However,
there are a number of very common and what appear to be
straightforward situations in which applying the guidance may
result in companies determining different levels of distributable
profit than they would have in the past.
For example, those preference shares that are accounted for as
compound instruments will be split between a liability element and
an equity element. The amount of interest charged to the profit and
loss account will be calculated by reference to the recognised
liability and, as such, will be higher than what is actually paid.
However, this increase in the interest charge has no effect on
distributable profits because its effect on reserves is matched
against the existing equity element of the instrument. While these
amounts are matched for distributable profit purposes, they will
almost certainly be presented separately for accounting purposes
and, as a result, the balance of retained profits will not
represent the company's distributable profit.
TECH 02/07 also reinforces existing guidance in relation to the
determination of distributable profit in groups. In particular,
where a holding company wants to pay dividends on the basis of
dividends received from its subsidiaries, those subsidiaries will
need to ensure that their dividends can be treated as realised by
the parent at the balance sheet date. For interim dividends, they
will need to be paid before the holding company's balance sheet
date. For final dividends, they will need to have been formally
declared at a general meeting prior to the holding company's
balance sheet date.
Furthermore, it should be remembered that profits which are
supported by intercompany borrowings are only realised to the
extent that the borrowings are readily convertible to cash. Loans
which are long term and/or unlikely to be called in the foreseeable
future would not normally be viewed as being readily convertible to
cash.
Smith & Williamson commentary
TECH 02/07 is a long document, and because it deals with a
combination of accounting and legal concepts, it may well seem
inaccessible to many readers. However, its provisions have very
real ramifications for companies that either pay dividends or want
to redeem shares out of profit. It is no longer possible to assume
that everything in the profit and loss account is automatically
distributable. Directors may therefore find they have to revisit
their previous methodology for determining distributable profit
and, in some cases, put in place new systems to keep the
distributable and non-distributable separate within the accounting
records.
Whenever there is uncertainty as to the level of
distributable profits available, appropriate professional advice
should be sought.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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