iGAAP Newsletter - Beyond the standards

Upfront

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.

Key considerations

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.

Distributions

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.

Realised profits

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.

Realised losses

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.

Relevant accounts

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...