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Distributable profits - how much do we have? Back  
At this time of year, many companies are busy making their final projections of profit for the year, and what will be in the pool of reserves for distribution to their shareholders says Brendan Sheridan. In group situations, companies will also need to focus on what amounts they need to be distributed from their subsidiaries before the year end in order to have sufficient reserves to meet dividend expectations.
The Transition to International Financial Reporting Standards (IFRS), the convergence of many UK/Irish Standards with IFRS, and constraints on when distributions can be included in financial statements, all lead to complexity in determining the amount of profits available for distribution.
The publication of Guidance (Technical Release (TR) 2/07): ‘Distributable Profits: Implications of Recent Accounting Changes’ by the Institutes of Chartered Accountants in England and Wales, and Scotland, is timely. While the Guidance is based on UK Company Law, in addition to Accounting Standards, it is helpful in Ireland as a starting point for considering what constitutes distributable reserves.

Development of Guidance
In 2003, the ICAEW issued TR 7/03 on this topic which was in advance of the transition to IFRS by many companies. In 2005, following transition to IFRS, draft guidance was issued for comment in the form of TR 21/05. Comments received were generally supportive but there was a call for redrafting in some areas to make the guidance clearer and more comprehensive, with one of the more significant issues being the implications of fair value accounting. This has led to TR 2/07. TR 7/03 ‘Guidance on the Determination of Realised Profits and Losses in the context of Distributions under the Companies Act 2005’ continues to be relevant. TR 2/07 builds on this to deal with issues that did not arise under UK GAAP in 2003. Other ICAEW Guidance dealing specifically with employee/retirement benefits and employee share schemes will be consolidated with TR 2/07 in due course.

The Guidance is relevant to companies reporting under either IFRS or UK GAAP and represents generally accepted practice at 1 August 2007. Areas specifically excluded from the scope of the Guidance are life assurance and agricultural produce/biological assets albeit that the general principles will apply.

Notwithstanding this guidance, directors of Irish Companies need to be mindful of their wider fiduciary duties to ensure that the payment of any dividend regardless of the adequacy of distributable reserves, is not likely to prejudice any operational, financial or other standing of the company.

Principle Changes
One of our articles in 2005 focused on the changes in TR 21/05 when compared with the earlier guidance in TR 7/03. We focus in this article therefore on further changes made to arrive at the final Guidance in TR 2/07. Some of the main changes relate to:

- Fair Value Accounting
- Hedge Accounting
- Debt/Equity Classification
- Transition to IFRS
- Dividend Payments
- Employee Share Options

This is not intended to be a comprehensive list of all changes made. In relation to some of the above issues, changes made are fundamental while in other cases the changes are comprised of drafting improvements only.

Fair Value Accounting
FRS 18 ‘Accounting Policies’ states that it is generally accepted that profits shall be treated as realised only when realised in the form of cash or of other assets, the ultimate cash realisation of which can be assessed with reasonable certainty, commonly referred to as ‘qualifying consideration’.

The principles of realisation set out in TR 2/07 are consistent with FRS 18, irrespective of whether accounts are being prepared under IFRS or UK GAAP. In recognition of fair value accounting, the Guidance states that the FRS 18 definition of realised profits would embrace profits and losses arising from the recognition of changes in fair values, to the extent that they are readily convertible to cash. Not all profits recognised as a result of fair value accounting will meet this requirement.

In answering the question of what is ‘readily convertible to cash’, TR 2/07 sets out three criteria:-
- a value can be determined at which a transaction in the asset or liability could occur, at the date of determination, in its state at that date, without negotiation and/or marketing, to either convert to cash or close out the asset, liability or change in fair value;
- information such as prices, rates or other factors that market participants would consider in setting a price is observable; and
- the company must be able to cash or close out the asset, liability or change in fair value without leading to liquidation, material curtailment of operations or the undertaking of the transaction on adverse terms.

In summary, the profit must be capable of immediate realisation in an observable liquid market, without significant impact on the operating capability of the company.

Certain classes of investments are normally excluded from the scope of those assets where changes in fair value may potentially be treated as realised profits.

These include:-
- Unquoted Investments - even where fair value may be reliably determined, a period of marketing and/or negotiation would generally be required to dispose of such an investment;
- Strategic Investments - under a company’s business strategy, it may hold investments for strategic purposes. Such investments are not readily realisable as a company’s strategy cannot be readily changed so as to allow the investment to be realised immediately; and
- Investment Properties – an increase in fair value is not treated as a realised profit as a period of marketing and/or negotiation would be required for disposal.

Where a company holds a significant investment in a particular share, or other similar asset, a ‘block discount’ may arise if the entire holding was disposed of at the date of profit determination. Where it is determined that a ‘block discount’ exists in relation to a holding of securities traded in an active market, only the part of the profit that may not be realisable over a short period of time in the ordinary course of business should be treated as unrealised. Estimation of the unrealised profit requires the exercise of judgment by the company directors. If the fair value of an investment, calculated in accordance with IAS 39, indicates a loss, the full amount of the loss should be recognised.

Profits and losses on ‘available for sale’ financial assets under FRS 25/IAS 32 are recognised directly in equity until sold, or otherwise derecognised, at which time the cumulative profit or loss is recognised in equity (i.e. recycled).

Fair value losses, calculated in accordance with accounting standards, should be treated as realised losses where profits on remeasurement of the same asset or liability would be treated as realised profits.

Losses on assets will be unrealised losses where both of the following apply:-
- profits on remeasurement of the same asset would be unrealised; and
- the losses would not have been recorded had the asset been measured on the basis of historical/amortised cost less impairment provisions.

Similarly, cumulative fair value losses on a liability will be unrealised if both profits on the same liability would be unrealised, and the losses would not have been recorded otherwise than on a fair value basis.

Hedge Accounting
IFRS, and in particular IAS 39, imposes stringent requirements on hedge accounting with a number of classes of hedge accounting available.

TR 2/07 outlines the principle that where hedge accounting is in accordance with accounting standards, it is necessary to consider the combined effect of both sides of the hedging relationship to determine whether there is a realised profit or loss.

The different classes of hedge accounting considered
Fair value hedge accounting - as the gross profits or losses on remeasuring the hedging instrument and the hedged item are both recognised in the profit and loss account, the principles outlined earlier will apply.

Cash flow hedge accounting - the portion of the profit or loss on the hedging instrument, to the extent it is effective, is recognised directly in equity. Such profits and losses become realised only when the hedged transaction effects profit or loss, or IAS 39 otherwise requires them to be recycled through profit or loss. Any ineffective element recognised in profit or loss should be recognised in accordance with the criteria already outlined. Additional considerations may arise for regulated public companies under any applicable capital maintenance obligations.

Net Investment Hedge Accounting - this will generally arise only in consolidated financial statements which are not relevant for the purposes of determining distribution capability. However, the existence of overseas branches may lead to it being relevant for some companies.

TR 2/07 also provides guidance on ‘natural hedges’ where a company has used foreign currency borrowings to finance foreign equity investments.

Debt/Equity Classification
Under IFRS, Financial Instruments are presented according to the substance of the contractual arrangement, determined by the rules in IAS 32. Examples of this are:

- redeemable preference shares bearing mandatory dividends are presented as liabilities in the balance sheet, and their corresponding distributions as interest charges in the income statement; and compound financial instruments, e.g. convertible redeemable preference shares and convertible debt, are generally split between a liability and an equity component.

Key underlying factors
A distribution e.g. preference share dividend, or capital repayment may on occasion be presented as accounting losses. Such items remain, as a matter of law, distributions or capital repayments and thus are not counted as losses; an accrual for unpaid dividends on a capital repayment is not, as a matter of law, a loss and does not consume distributable profits until it is paid or declared by members in a general meeting; and a premium received by the writer of an option over its own equity shares is regarded as a profit at law, and is distributable provided it is received in the form of qualifying consideration.

Dividends
Adoption of IAS 10 (FRS 21) has the effect of changing the timing of recognition of dividends payable and receivable. In summary, in order to be included in financial statements for a particular year, dividends must be appropriately authorised and no longer at the discretion of the entity. To achieve this, interim dividends must be paid and final dividends must be approved at a general meeting.

What constitutes payment of an interim dividend may in some circumstances require legal interpretation, particularly where the dividend is recorded on an inter-company account and the book entry creates and/or increases a liability of the paying subsidiary.

It may be necessary for subsidiary companies to pay up interim dividends before the parent company’s reporting date to ensure it has adequate distributable reserves to support the expected level of the proposed final dividend.

Transition to IFRS
Fully-listed companies, preparing group accounts, have already made the transition to IFRS. For companies listed on secondary markets, e.g. AIM, and private companies electing to make the transition, TR 2/07 provides guidance on transition to IFRS. This may be of particular relevance to AIM – listed companies which are required to make the transition for accounting periods beginning on or after 1 January 2007.

IFRS is a different accounting basis and will lead to changes in accounting policy and estimate, many of which may be significant to retained earnings. The lawfulness of a distribution made prior to transition should normally not be in question as Company Law defines realised profits and losses as being such profits and losses that fall to be treated as realised in accordance with principles generally accepted at the time when the accounts are prepared.

Share option schemes
The International Financial Reporting Interpretation Committee issued in November 2006 IFRIC 11 ‘IFRS 2 - Group and Treasury Share Transactions’. IFRIC 11 does not address the question of where a subsidiary makes a cash payment to its parent in settlement of an equity-settled share-based payment in excess of the original charge, whether any such payment is a distribution in the company’s accounts. The accounting treatment of any such ‘excess payment’ does not affect whether or not it is a distribution as a matter of law as, in particular if there is a commercial basis (e.g. increase from grant date value to current intrinsic share value), it will not be a distribution. The Guidance states that it will not be unlawful for the subsidiary to make the re-imbursement payment even in the absence of distributable profits. However, the re-imbursement payment will reduce accumulated realised profits where the credit to equity, the corresponding entry to the share-based payment charge, has been treated as retained profits.
The guidance in TR 2/07 runs to 92 pages. The above is a brief synopsis of the main changes which have arisen particularly on foot of IFRS, or the equivalent UK/Irish standards. TR 2/07 includes guidance on the impact of a large number of other accounting issues on distributable profits.

The Guidance is most welcome at a time when many may have concerns regarding defining the amount of profit that may be considered as realised and therefore distributable. It does not replace the need for companies to consult with their legal advisors where complex questions may arise.

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