New proposals to make disclosure of distributable reserves mandatoryPrint publication
Concerns are mounting that the capital maintenance regime is being undermined and that the time has come for the disclosure of distributable and non-distributable reserves to be mandatory within a company’s audited accounts.
Over the last few months there have been numerous reviews and consultations into various aspects of the statutory audit, largely as a result of some high profile company failures. One area where attention has been focussed in several of the reviews is that of distributable reserves and the payment of dividends.
In March 2019, the Business, Energy and Industrial Strategy Committee (the BEIS Committee) produced a report entitled ‘The Future of Audit’ (the BEIS Report) in which it examined one of the core reporting and audit failures that led to the demise of Carillion plc, that of “the impudent payment of dividends out of optimistically booked, and in hindsight unrealised, profits.”
One of the central purposes of producing accounts is to determine a company’s profits, which in turn allows a decision to be made on what proportion of these profits are distributable in the form of dividends to shareholders. Companies can only pay dividends out of past, realised profits which are available for distribution in the company’s distributable reserves.
The law that governs the payment of dividends and protects a company’s share capital is called the ‘capital maintenance regime’ and concern was expressed in the BEIS Report that audit firms and investors have lost sight of capital maintenance as a central purpose of accounts and audit and furthermore that there is little compliance with the regime. Four examples in the BEIS Report illustrate the current poor practice in relation to capital maintenance and the payment of dividends:
- Domino’s Pizza Group plc – £85 million of unlawful distributions over a period of 16 years from 2000;
- Carillion plc – £333 million paid out in dividends between January 2012 and June 2017 which was more than the company generated in cash from its operations in the same period;
- Capita plc – £211 million paid out in dividends in 2017 followed in January 2018 by a request for a £700 million rescue from shareholders;
- AssetCo plc – paid large dividends in 2009 and 2010 despite there being no distributable reserves available.
In its study into the audit market, the Competition & Markets Authority (CMA) stated that the current audit framework and accounting standards fail to deliver a key purpose of audit which is to assess whether a company’s capital is properly protected. The CMA’s view is that because accounts are prepared in accordance with accounting standards, and auditors review the accounts against these standards, the Companies Act 2006 requirements are not necessarily met, a case of company law following the standards rather than the other way around. This was highlighted in the BEIS Report as totally unsatisfactory and an argument put forward that reserves should be broken down in the accounts into distributable and non-distributable and profits between realised and unrealised. Furthermore, realised profits should be those that are realised in cash or near cash (i.e. assets that can readily be converted into cash) and should not include accrued income. The concern of the BEIS Committee is that if directors are permitted to distribute income that they expect to receive, then there are significant risks that in the event that the expected income never materialises, dividends could be paid out of capital, thereby contravening company law.
This idea of identifying distributable and non-distributable reserves in the audited financial statements has also been proposed by the Investment Association (IA). In its response to the ‘Call for Views’ following the review into the quality and effectiveness of audit carried out by Sir Donald Brydon, the IA stated that companies should be required to disclose distributable and non-distributable reserves in their audited accounts. In the IA’s view this disclosure would enhance investors’ confidence in management’s stewardship by demonstrating that dividends are not being proposed out of capital and clarify the headroom between the level of reserves and the proposed dividend. If this information is included in the audited financial statements then it will be subject to the audit. In this context, the IA’s recent report on dividend payments also calls for companies to improve their transparency and publish a ‘distribution policy’ setting out their approach to paying dividends to shareholders.
Although these proposals are some way from becoming law it’s clear that the capital maintenance regime and payment of dividends is a hot topic at the moment. We would not be surprised if the rules were tightened so that distributable and non-distributable reserves have to be identified in the financial statements together with a more restrictive definition of realised profits. This is an important area for all members of the board, not just the FD, as it impacts directly on directors’ duties. Directors need to consider both the immediate cash flow implications of a distribution and the continuing ability of the company to pay its debts in order to discharge their duties. Directors may also be in breach of their fiduciary duties in authorising or permitting the company to pay an unlawful dividend and can be made to personally repay the amount of the unlawful distribution. The Corporate team at Walker Morris are well placed to help you understand the capital maintenance regime and would be happy to help prepare your board for the likely changes. The question of whether reserves are distributable or non-distributable will take on more importance and directors need to understand the difference.