The Rules: FRS 102 poses risk of dividend block

FRS 102 has been at the forefront of many auditors’ and accountants’ minds for a while and hopefully by now you are familiar with the key changes that FRS 102 will have on your financial statements. But have you considered how this will impact your dividend policy? And what indirect impact that may have on your business?

As FRS 102 changes the measurement of certain assets and liabilities, and brings certain liabilities onto the balance sheet that were previously not recognised, it can have a negative impact on the ability of a company to pay dividends. This is particularly relevant for those businesses with a history or stated policy of paying dividends to shareholders. In addition, some of the new accounting policies introduced by FRS 102 can also impact distributable reserves.

The determination of distributable profits and the legality of dividends is the responsibility of the company’s directors but as finance director you will have a key role in the relevant analysis and in considering the effect of adopting FRS 102 on the expected levels of profit available for distribution.

Some of the new accounting policies introduced by FRS 102 will reduce retained earnings at the date of transition, thus having a negative impact on distributable reserves at that point and hence the level of dividend that can be paid by reference to the first set of accounts prepared under FRS 102. Furthermore, the likely impact of those forthcoming adjustments must be considered when determining the amount of any dividend declared in respect of the year preceding the adoption of FRS 102 but which will not actually be paid until the following year – for instance, in the year in which FRS 102 is first adopted. In that situation you can’t just turn a blind eye to the future impact of those adjustments on distributable reserves.

Potential impacts
There are many accounting policies that could impact distributable reserves on transition but some of the potentially significant adjustments relate to recognition of group defined benefit liabilities (previously only recognised in consolidated accounts) on balance sheet in the sponsoring entity’s individual accounts; and bringing derivatives on balance sheet at fair value.

These could potentially have a huge impact on distributable profits at transition which might take years to rectify. Some of the changes will affect distributable profits in the future, too. Changes common to many businesses that could have a varying impact on distributable profits, both on transition and in the future, include recognition of intragroup loans not at market value and holiday pay accruals. Also, any cumulative net fair value losses on investment property where recovery is in doubt will hit distributable reserves but, on the contrary, fair value gains do not count as an increase in distributable reserves.

In some instances, the impact can be reduced by adopting various transitional provisions or accounting policy choices. For instance, choosing to adopt hedge accounting can, in the case of an effective hedge, be used to minimise profit volatility and the impact on distributable reserves of having to book derivatives at fair value. However, the pros and cons of adopting hedge accounting vary considerably from business to business and the documentation and accounting can be complex. There are also tax implications to consider.

Equally, some of the strategies being considered by businesses to minimise the impact of FRS 102 in other areas might also affect distributable profits and so should be assessed carefully before thinking they are foolproof plans. For example, waiving intragroup debt in order to avoid dealing with the complexities of off-market interest rates may result in a distribution where a subsidiary has loaned money to the parent. Equally, transferring pension liabilities around the group may cause similar problems. Parent companies transferring pension liabilities to a subsidiary for less than full consideration are receiving a distribution from their subsidiary. Such strategies could result in just transferring a dividend block problem to another part of the group or causing unlawful distributions where the subsidiary does not have sufficient distributable reserves.

How will investors react?
So what are the implications of not planning for these changes? If transition to FRS 102 wipes out distributable reserves and dividends cannot be paid, how will your investors react? There are also the legal aspects to consider. By paying dividends which are unlawful, no matter how inadvertently, directors may find themselves exposed to liability and potentially having to ask shareholders to return the dividend.

Many tax efficient reward structures for key management involve a mix of salary, dividends and share options. Any constraint on dividend policy as a result of adopting FRS 102 could influence the incentive of these reward schemes, particularly given the forthcoming increases in the taxation of dividends.

So what should you do? The key is to plan for these changes as early as possible.

Start an impact assessment and investigate the options available to you to mitigate any unwanted effects. For many of you, the next financial statements your business prepares will be the first FRS 102 accounts. Have you checked that you have sufficient distributable reserves under the adjusted FRS 102 figures? This is a good time to consider not just the accounting implications but also the legal and tax consequences. Is the impact on the dividend policy temporary or more long term? Does the business have any reward schemes sensitive to dividend changes? What might the impact be on the ability to attract investment and other sources of finance?

Tessa Burt, Manager, national assurance services, Grant Thornton UK