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ICAEW Technical Release 7/03 - Realised profits and losses

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28th Oct 2003
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Distributing dividends without determining profits according to the accounting standards in issue could put company directors at risk of being personally liable for the outstanding funds.

This Solomon Hare technical circular provides an overview of ICAEW Technical Release 07/03 issued in July 2003 on the determination of realised profits and losses for the purposes of the Companies Act 1985.

1 INTRODUCTION
The Technical Release (TR) updates guidance previously given in ICAEW Technical Releases 481 and 482 issued in September 1982. The objective is to provide guidance on the determination of 'realised profits and losses' for the purposes of the Companies Act 1985 (CA85). It does not however apply to the special circumstances of investment companies and insurance companies.

A company's profits available for distribution are defined in section 263(3) of CA85. This refers to realised profits and losses which are in turn defined in section 262(3). It is important to note that 'the concept of a realised profit is intended to be dynamic'. This indicates that the concept should reflect changes in generally accepted accounting principles. New accounting standards only become relevant to distributions proposed in respect of periods when the changes they introduce will first be recognised in a set of accounts.

While the existence of realised profits may indicate that the directors of a company may declare a dividend, they must still have regard to the company's cash flow position and its ability to pay its debts as they fall due. If there is doubt on this aspect, in order to fulfil their fiduciary duty, the distribution should not be made.

The TR provides definitions of the following terms:

  • Profit
  • Realised profit
  • Realised loss
  • Qualifying consideration; and
  • Asset for which there is a liquid market.

The meaning of these terms is quite complex. Therefore, when considering this matter in practice it may be advisable to refer to these definitions to ensure the appropriateness of a proposed distribution.

It is important to note that the guidance in this TR should not be used to question the lawfulness of previous distributions. However, existing reserve balances may need to be re-examined in the light of the guidance before further distributions are made.

2. PRINCIPLES OF REALISATION
Profits available for distribution are derived from a company's accounts. It is vital, therefore, that those accounts have been properly prepared in accordance with the law and generally accepted accounting principles. The available profits may include amounts reported in the Statement of Total Recognised Gains and Losses (STRGL) and the Reconciliation of Movements in Shareholders' Funds as well as those reported in the Profit and Loss Account.

FRS 18 'Accounting policies' says that profits should 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'. The TR indicates that this would include profits and losses arising from the use of the marking to market method of accounting where this has been properly adopted.

Transactions should not be looked at in isolation, rather the overall commercial effect must be examined in accordance with FRS 5 'Reporting the substance of transactions'. Therefore a group, or series, of transactions must be viewed together to determine whether realised profits arise. Particular care should be taken over transactions that appear to be artificial, linked or circular.

3. CHANGES IN CIRCUMSTANCES
The treatment of a profit, or loss, previously treated as realised, or unrealised, may change due to:

  • Changes in the principles of realisation
  • Changes to the law or accounting standards
  • Changes in circumstances or assumptions.

At the time of recognition such changes may reduce, or eliminate, a company's realised, and therefore distributable, profits. However, this does not render unlawful a previous distribution, provided that at the time it was made it was lawful.

Where the directors are considering the payment of an interim dividend, they must have regard to the effect of any new accounting standards, or other rules, that may affect distributable profits as shown in the forthcoming year end accounts. If a new accounting standard increases available profits and the directors wish to pay an interim dividend greater than the distributable profits shown in the last accounts, they should prepare interim accounts complying with the new standard.

4. APPLICATION
The TR provides a number of practical examples illustrating what may be treated as realised profits and losses:

  • Instances of realised profit:
    • receipt/accrual of investment or other income in the form of qualifying consideration
    • gain on a return of capital on an investment in the form of qualifying consideration
    • gift (eg a capital contribution) in the form of qualifying consideration
    • release of a provision for a liability or loss that was treated as a realised loss
    • reversal of a write-down or provision for diminution in value or impairment of an asset that was previously treated as a realised loss;
    • reduction or cancellation of capital confirmed by the court resulting in a credit to reserves except where the company has given an undertaking, or the court has directed, that it should not be treated as a realised profit;

  • Instances of realised loss:
    • cost or expense (except one properly charged to share premium) reducing net assets
    • loss on sale or scrapping of an asset
    • writing-down, or provision for depreciation/amortisation/impairment of an asset
    • creation of, or increase in, provision for liability or loss that reduces net assets
    • gift made, release of debt due, or assumption of a liability that reduces net assets;

  • Exchange of assets ' if an asset is sold partly for qualifying consideration the realised profit is restricted to the amount of the qualifying consideration.
  • Foreign exchange ' generally, the profits and losses arising on the retranslation of monetary items in the accounts of an individual company are treated as realised.
  • Marking to market ' where the method is in accordance with law and generally accepted accounting principles, profits and losses are treated as realised.
  • Goodwill:
    • positive ' a realised loss arises as it is amortised or impaired
    • negative ' a realised profit arises as it is amortised or impaired, except where taken to the profit and loss account on the sale of a non-monetary asset for non-qualifying consideration
    • where it was taken direct to reserves under the former SSAP 22, and the transitional rules in FRS 10 have been adopted, it becomes a realised loss or profit over its expected useful life as if it had been capitalised and amortised in accordance with FRS 10.

5. TRANSACTIONS IN A GROUP
It is possible, within a group, to create profits in individual companies by undertaking transactions with other members of the group. Appendix A to the TR provides guidance on a number of circumstances and whether any profits so created are distributable. The guidance covers:

  • Cash pooling arrangements and group treasury functions
  • Dividends from subsidiaries:
    • generally
    • funds reinvested in the subsidiary
    • from pre-acquisition profits;

  • Sale of an asset:
  • generally
  • followed by dividend to parent of the resulting profit;

  • Dividend in specie
  • Return of capital contribution.

    6. LEGAL FRAMEWORK
    A useful summary of the law regarding realised profits is in Appendix B to the TR. This covers matters such as:

    • Distributions
    • Profits available for distribution
    • Relevant, initial and interim accounts:
        all companies
      • public companies;

    • Special rules for public companies
    • Provisions and asset revaluations
    • Development costs.

    7. OTHER MATTERS
    The TR reflects the law and accounting standards at 31 December 2002.

    Where there are particular issues facing a company regarding a proposed distribution reference should be made to both the Companies Act and the full text of the TR and the definitions in particular.

    Solomon Hare Financial Reporting Alerts This circular provides an overview of the topic. Therefore no responsibility is accepted for any loss arising as a result of any person relying on this summary. Specific advice should be sought before proceeding with any proposed action.

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