UK: UK GAAP - Distributable Profits

Last Updated: 2 April 2008
Article by Yvonne Lang

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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