Will The New Accounting Standard Affect Dividends?

The new Financial Reporting Standard FRS102 is a comprehensive single reporting standard that basically replaces all previous standards, statements of practice, and related abstracts. It is based on the international standard for Small and Medium-Sized Enterprises (SMEs), but has been amended to comply with the UK Companies Act 2006, and to allow more freedom to continue to use some existing accounting policies that are in line with the new standard.

While I generally find the news that there is a new accounting standard about as exciting as choosing a brand of photocopier paper, the scale of the overhaul in this case means that there may well be real consequences for ordinary SMEs that adopt the standard, notably in relation to the company’s distributable profits and the availability of dividends.

FRS102 basically applies for accounting periods starting on or after 1 January 2015, so 2016 year ends will generally be the first under the new regime.

A company can pay dividends only out of ‘distributable profits’. Simply put, these are the accumulated profits since the company was first created, less accumulated losses and any dividends already paid out. 

A company may have accumulated substantial reserves (profits) over many years, because it has consistently paid out less in dividends than the profits it has made. However, many smaller companies pay out most of their annual profits in dividends, leaving only a small amount to carry forward. Even relatively small changes in accounting policy, as may be required under FRS102, may affect the company’s distributable reserves. It might be quite an unwelcome surprise to find that distributable reserves – and therefore the dividend you can pay out – are lower than you would have expected. 

One issue will be the valuation of investment properties. In the past, where a property was revalued, movements would have been taken to a separate ‘revaluation reserve’. In other words:

‘The company’s investment property is estimated to be worth £50,000 more than when it was originally acquired, and this is being adjusted for in the accounts. But this is not being treated as a ‘real’ profit, because the property has not been sold and it may fall in value in future, before it ends up being sold. So the movement in value is moved to a separate ‘revaluation reserve’ instead of being included in the company’s profit and loss account. If and when the investment property is sold, then any actual profit will be recognised as real and distributable’. 

Simply put, the problem with FRS102 in this regard is that it wants the revaluation to be recognised in the company’s profit and loss account, even though any increase in value will still not count as having been realised, so will not form part of the distributable profits for the purposes of paying out dividends. The risk is that the business owner/director might find that the amount that can be paid out in dividends is rather less than the accumulated profits figure he or she is used to basing his or her dividend on (note that, if the investment property falls in value below original cost, then this may actually reduce the company’s distributable reserves, and thereby the scope to pay out dividends). 

Directors' loan accounts may also need to be revalued in some cases

Where a loan is repayable on demand, then its current value is basically unaffected. But if a loan term is fixed (for example where the directors want to show their loans as longer-term creditors), the current or present value of the loan may need to be re-calculated.

John’s director’s loan account (DLA) is used casually, and is repayable by the company if and when John decides he wants to be repaid. 

Basically, because he could insist on repayment tomorrow, the company’s debt to John is recognised at ‘face value’ and FRS102 makes no changes.

Edwina has invested £50,000 into her company, along with her two other fellow shareholder/directors. 

The directors commit to not insisting on their respective loans being repaid for (say) the next five years, so that the company can recognise the loans as long-term liabilities. In common with most DLAs, there are no arrangements for the company to pay interest for the use of the directors’ money. 

Under the new FRS102, the company should recognise the loans as if they were commercial loans charging realistic rates of interest. This would involve valuing the loan debt initially at less than its face value, and charging a hypothetical commercial rate of interest on the loan until, at the end of year five (being the loan term): the lower initial value plus accumulated hypothetical interest equals the £50,000 x 3 repaid to Edwina and her fellow directors at the end of the term.

Another way of looking at the adjustments is that by reducing the initial value of the loans, the company is recognising that its obligation to pay £150,000 in five years’ time is actually worth less than £150,000 today, be it due to inflation, investment returns, etc. 

Just as with the investment property above, such interest adjustments may affect the profit and loss account, even if they do not affect the distributable reserves for the purposes of dividends. There is again a risk that the director/shareholders may be able to draw out less in dividends than the accounts would indicate.

Other changes to consider

FRS102 reminds me of why I gave up auditing and chose tax. I suppose one should resist the temptation to ban holiday pay as a possible solution, as one might then have to make an even bigger provision for legal claims. Many of the changes that FRS102 requires will not affect distributable profits and the amount of dividends that may be paid out, but may change only the profits on the face of the accounts, to catch out the unwary.

It has been my experience that most DLAs, whether overdrawn or in credit, are repayable on demand rather than having any plan for repayment, and I think that may well prove to be even more the case, in future. 

I have, however, encountered a few companies that have intentionally set out terms for DLA repayments for eminently practical reasons; where this applies, and assuming the company has adopted FRS102, it may now be necessary to re-visit the arrangements and re-value the loans – and then consider the impact on the company’s profit and loss account, if not on distributable reserves and dividends. 

Not all companies need adopt FRS102, since smaller entities may instead choose the FRSSE (FRS for Smaller Entities) and micro-entities FRS105. Directors/shareholders should check with their professional adviser to find out what standards their company may choose to adopt, and which is best for their circumstances.