Opinion Piece on BEIS Committee recommendations on capital maintenance

Amy Hutchinson By Amy Hutchison, Head of Corporate and Financial Reporting

11 April 2019

In the second of a series of articles by the ICAS Standards Division looking at the BEIS Committee report on the Future of Audit, Amy Hutchinson, Head of Corporate & Financial Reporting, looks at their proposals on capital maintenance.

The Business Energy and Industrial Strategy (BEIS) Committee report on the Future of Audit makes a number of recommendations aimed at addressing a perceived lack of compliance with and enforcement of the capital maintenance regime – in particular, recommending that the Financial Reporting Council (FRC) and government act to develop ‘simple and prudent’ guidance on the definition and application of the distributable profits regime.

As the BEIS report highlights, the current guidance on distributable profits (prepared by ICAS and ICAEW) runs to 173 pages, therefore the desire for simplification is easy to understand, but may not be achievable in practice.

The requirements for distributions under company law are substantially unchanged since they were first introduced in the Companies Act 1980. In essence, dividends can only be paid out of ‘realised profits’ which are defined in the Companies Act as ‘such profits or losses as fall to be treated in accordance with principles generally accepted at the time’. Therefore the concept is dynamic as what constitutes generally accepted accounting practice changes over time.

The BEIS report attributes the complexity of the current capital maintenance regime to the increased use of fair value accounting under International Financial Reporting Standards (IFRS), which it states has resulted in companies paying dividends out of capital. Whilst the development of accounting standards is undoubtedly a factor, there are other elements which mean that the desire for simplified guidance may be unrealistic:

  • As business models and financial markets have become more complex, accounting standard-setters have had to develop new ways of accounting for items such as complex financial instruments, for which historic cost would generally be irrelevant.
  • Dividends are paid by individual companies but most major companies are part of a larger group structure, and a considerable portion of the current guidance deals with intra-group transactions which can have an impact on the availability of distributable profits.

So, although it may be possible to simplify the guidance, and this may be sufficient for simple standalone companies with relatively straightforward accounting transactions, it’s likely there would be many areas in which companies and auditors would still seek additional interpretation.

The committee supports defining ‘realised profits‘ as ‘realised in cash or near cash’ - the latter is not defined, but at first glance does not seem too far from the current definition which hinges on the term ‘qualifying consideration’. This is essentially cash, an asset readily convertible to cash or the release, or settlement or assumption by another party, of liability of the company. Items such as gains on financial instruments valued using a valuation model cannot be treated as realised, as these are not readily convertible to cash.

It’s not clear, therefore, what changes in practice this new definition would bring, unless the implication is that ‘cash or near cash’ has a much narrower meaning. The report references an evidence submission stating that realised profits should not include ‘accrued income’ - suggesting a cash-only approach to distributions. If this is the intention, it would have significant implications for the level of dividends companies are able to pay. It is worth noting that other EU states do not use such a restrictive definition of ‘realised profits’ as the UK does, despite the distributable profits regime being set out in EU company law.

A further recommendation is that ‘profits should be broken down in the accounts between realised and unrealised, and reserves between distributable and undistributable'.  A high-level desktop review of the annual reports of some of the UK’s largest companies found that a number already disclose a note about the amount of retained earnings that is non-distributable within the financial statements. Perhaps greater standardisation and prominence of this information would provide greater comfort to investors and other stakeholders.

The accountancy profession has been grappling with the issue of distributable profits for many years now, and it is perhaps inevitable that the BEIS committee’s analysis seems rather superficial.

Topics

  • Audit and Assurance

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