Realised and unrealised profits | KPMG | UK

Realised and unrealised profits: why it’s vital to know the difference

Realised and unrealised profits

Directors need to ensure that any distributions made are lawful. What does and doesn’t qualify as a realised profit can be difficult to determine.

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Realised and unrealised profits: why it’s vital to know the difference - Piggy Bank Illustration

It is one of the many duties of a director to ensure that any distributions made – for example, cash dividends, share-buy-backs or the redemption of preference shares – are lawful. A dividend unlawfully paid is usually repayable to the company by its members or, in some cases, by the directors.

The UK has strict rules on capital maintenance. These require that distributions are only made out of realised and therefore distributable profits, including certain rules specific to public companies. These are determined with reference to a company’s financial statements – referred to in law as ‘the relevant accounts’. However, accounting profits don’t always equal profits available for distribution.

What does – and doesn’t – qualify as realised profits can sometimes be difficult to determine and often requires careful analysis on the part of directors.

Below are some of the scenarios we have encountered in practice, relevant to both IFRS and UK GAAP users alike. The need to assess realised profits is the same, regardless of the GAAP applied.

Scenario 1: What happens with redeemable preference shares that are accounted for as a liability?

An area where we often see unlawful distributions made inadvertently is in cases where the accounting entries differ from the treatment in law. That could be, for example, shares classified as debt in accordance with accounting standards as described below:

A company has issued redeemable preference shares with a mandatory coupon that are redeemable in the current financial year.

Here we have two instances where the accounting outcome is different to how the preference shares and coupon are treated under company law.

As the shares are presented as a loan, many people often overlook the fact that the underlying instrument is a share. As a result, directors might believe they are repaying a loan when, as a matter of legal fact, shares are redeemed. The redemption of a preference share is a repurchase of own shares and can only be lawfully done out of distributable profits.

Furthermore, although the interest expense is recognised in the P&L as a charge and therefore reduces the accounting profits, it is ignored for the purpose of determining distributable profits: in law, the coupon is treated as a dividend when paid.

Scenario 2: What is the effect of first time adoption of IFRS 15 and IFRS 9?

Many UK companies will have transitioned to IFRS 9 and IFRS 15 on 1 January 2018 or 1 April 2018. For some entities, this will affect cumulative profits.

Directors need to think about the effect of the transition when determining profits available for distribution. The level of dividends is normally calculated with reference to the last annual accounts. However, the guidance in Tech 02/17 reminds directors that they need to consider any losses incurred after the balance sheet date, including the effect of the application of new accounting standards. This will include any losses arising from transition adjustments. Directors need to consider in their first distributions of 2018 whether the transition adjustments that were applicable in the 1 January 2018 financial statements have depleted the distributable profits included in the 2017 financial statements.

Scenario 3: Where do relevant accounts fit in?

Distributions – cash dividends or otherwise – can only be made if they are supported by cumulative realised profits in ‘relevant accounts’. These are generally the most recent annual financial statements.

However, consider a scenario where a parent company shows negligible realised profits in their annual accounts and receives a dividend from their subsidiary only after the year end. Before the entity can onwards distribute these amounts, the directors need to prepare relevant accounts which include any additional profits/losses made in the period since the year end, as well as the dividends received from the subsidiary.

For a public company, these interim accounts need to be filed with Companies House (there is no requirement for an audit). A distribution without filed interim accounts is unlawful. The rules for private companies, however, are less strict. Management accounts that enable a reasonable judgement to be made as to profits, losses, assets and liabilities, provisions and reserves are sufficient.

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