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Comments from the Association of Chartered Certified Accountants

September 2000

Executive Summary

The Association of Chartered Certified Accountants (ACCA) is pleased to have this opportunity to respond to the draft guidance "The determination of realised profits and distributable profits in the context of the Companies Act 1985" published by the Institute. It was considered at a recent meeting of the Financial Reporting Committee and I am writing to give you their views.

We sent comments on the previous draft of this guidance in October 1999. We notice that while the guidance has been improved since then, the essence of its approach remains the same and that many of our comments made then have not been addressed by the changes made, and therefore still apply.

Our concerns can be put under three headings.

• The principle that there is a concept "realised profits and losses" which is capable of definition quite separately from the recognition of gains and losses.
• Even accepting that this might be possible, whether this guidance is coherent
• The degree to which this guidance represents a current consensus of legal opinion

Separate concept of realisation

We remain of the view that the concept of realised profits and losses as distinct from recognised gains is not satisfactory and the search for such a concept will ultimately be fruitless. Without a clear concept of realisation the development of a practical definition will tend to be arbitrary and subject to inconsistencies and exceptions, and therefore may not work.

In our response to the recent consultation on capital maintenance from the Company Law Review, we expressed a preference for moving away from an accounts-based limit on distributions towards a procedure based on solvency tests. We proposed that most of the existing rules in sections 263 to 270 of the Companies Act 1985 would be removed. In their place we suggested:

• A statutory duty on directors to consider the ability of the company to make the proposed distribution and still continue to meet its obligations as they fall due. In order to protect the company against capital reduction, a distribution should not reduce net assets below contributed capital (for which the accounting standards body could be asked to provide a definition and any guidance)
• There should be a formal statement of the directors' opinion on these matters for each distribution at the time of its approval
• Where the company is required to have auditors they should provide assurance in support of the directors' statement, in a similar way to the current regime on financial assistance and the purchase of a company's own shares

Internal coherence of the guidance

Even if it were to be accepted that a separate concept of realised profits should be pursued, we consider that the draft guidance lacks internal coherence in some respects, and that these inconsistencies may create practical problems when preparers and auditors try to apply this guidance.

Paragraph 12 appears to be applied only to group transactions, via some of the examples in Appendix A. It is a difficult principle, especially for group transactions which may often not be at arm's length, and may be artificial in that sense. The draft guidance, on the other hand does not address other comparable instances where unconnected parties are involved, for example sales of assets which are then leased back under an operating lease..

The word "necessarily" in the first sentence of paragraph 12 is an unhelpful qualification.

Paragraph 13 of the draft refers to the need to follow generally accepted accounting principles, of which accounting standards are the prime element. Paragraph 16(d) allows a profit to be realised as a result of marking to market of current assets and liabilities. Currently, however, there is no specific requirement or option in UK standards to show current assets and liabilities at fair value and take the gain to P&L account. There must be some doubt therefore at present whether the marking to market of current assets and liabilities is in accordance with generally accepted accounting principles. The document does not address this inconsistency.

In addition this phrase "marking to market" is not defined in the draft, nor is it defined as far as we are aware in any UK accounting standard. In the absence of a definition or an accounting standard it is noticeable that no restriction is placed on the use of marking to market to produce realised profits, other than it must be of current assets or liabilities.

Paragraph 13 also requires that before a profit can be realised it must have been recorded. If there is some inherent quality to the realisation of a profit, then whether it is recorded or not would not affect that quality. Indeed Paragraph B26 includes a case where the recording of gains is not needed.

In Paragraph 16(d) it is not clear why realised gains from the revaluation of assets would be restricted to current assets and would not be extended to any investments, for example, which have been treated as fixed assets. Whether treated as current or fixed assets the valuations of such investments might be just as reliable. Equally mark to market gains would be restricted to current liabilities and not allowed on liabilities due after more than one year. Under 16(e), however, no such current asset/liability restriction applies to the revaluation in respect of currency exchange rates. The guidance should explain such inconsistencies.

Paragraph 16(f) does not seem clear. Is the reversal of an unrealised loss to be treated as a realised profit?

Paragraph 17 would be improved by the provision of a list of specified unrealised losses.

In Paragraph 21 there is no definition of what is a reasonable period of time in this context.

In relation to the last sentence of Paragraph 25, it might not always be clear whether a particular profit had been distributed or not. The guidance does not propose whether realised profits are to be accounted for on a FIFO, LIFO or other basis.

Paragraph 32 refers to the case of goodwill which might have been written off under SSAP20 "as a matter of accounting policy". This guidance should either deal with this in a general way or refer to other cases where accounting standards offer alternative treatments which could affect distributable profits, for instance development costs under SSAP13 or interest costs under FRS15.

We find some of the examples in Appendix A inconsistent. For example in A4 dividends paid via an increase in debt where group treasury arrangements exist, would be realised profits in the parent. In A6, A8 and A10 on the other hand if funds have been provided directly or indirectly by the parent, then the profit is not realised.

Current legal consensus

In our letter of October 1999 we expressed concerns that the guidance provided might be significantly more restrictive than some current practice and legal opinion. This was particularly in terms of intra-group transactions and those cases where cash has been received, but where there may have been other linked transactions that would nevertheless render the profits unrealised. Those concerns remain.

We think that the publication of the counsel's opinion referred to in Paragraph 2 will be important to allay such concerns. The widest possible endorsement (perhaps by the bodies representing solicitors as well as accountants) of the guidance would also help.

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