The law of unintended consequences is one that has stood the test of time and is now coming to bear on how companies determine the extent to which they can distribute their profits to shareholders. We are in a period of change in accounting standards. The problem is that, while accounting standards focus on communicating performance to the owners of the business, company accounts are also used for various other purposes in law. These include the determination of what is a realised profit and hence distributable to shareholders.
The biggest change relates to the move to International Financial Reporting Standards (IFRS) in Europe, which is compulsory from this year for listed company group accounts. Listed and unlisted companies also have the option to switch the accounts of all subsidiaries and the parent company to IFRS and it is these that are used to calculate what dividends can be paid. However, companies taking up this option are finding that it can have severe consequences for distributable profits, often creating dividend blocks, even though the overall financial position has not changed. This is particularly so where a group has been acquisitive or has undertaken group reorganisations.
However, there is no real escape by staying on UK standards. The UK standard-setter, the Accounting Standards Board (ASB), has a stated policy of converging UK standards with IFRS over the next few years. Although this means that some of the adverse impacts of IFRS on distributable profits may not take effect immediately, they will soon, and some changes are coming in immediately. Nowhere is the impact more pronounced than in relation to pensions.
From this year, deficits and surpluses on company pension schemes will come on balance sheet through the full implementation of the UK standard FRS 17 ‘Retirement Benefits’. Companies with significant deficits on their defined benefit pension schemes are finding that the deficit is eating into, or even wiping out, their distributable profits. The equivalent international standard, IAS 19 ‘Employment Benefits’, has a similar impact, although not necessarily quite so severe.
One of the most extreme examples reported recently was that of British Airways. The airline has one of the largest pension deficits in the listed sector and it looks like its pension deficit has effectively wiped out distributable profits at the parent company level.
So what action can companies take? It is vital that companies have an up-to-date picture. Bodies issuing guidance are the institutes of chartered accountants (information can be found on the Institute of Chartered Accountants in England and Wales website at www.icaew.co.uk) and new draft guidance on the impact of IFRS on distributable profits has just been published. There is some scope for restructuring to get round some of the problems, but this may be restricted in relation to pensions because of recent pensions legislation and the creation of the Pension Protection Fund (PPF). Broadly speaking, arrangements that change the covenant of a group with its pension fund will require clearance from the PPF. The pensions area is also complicated by the differences between UK and international standards, particularly the extent to which an overall group scheme deficit has to be shared out in the accounts of individual group companies.
On a longer-term basis, the European Commission has started to consider the capital maintenance rules in the Second Company Law Directive and whether it would be possible to weaken the link between the ability to distribute and company accounts. This will take some years. In the meantime, the Department of Trade and Industry is being lobbied to relax the UK position for unlisted companies in UK law, which, as the EU legislation only applies to listed companies, should be possible.
Kathryn Cearns, consultant accountant, Herbert Smith