The law of unintended consequences is one law that has stood the test of time and it is coming to bear on the impact of International Financial Reporting Standards (IFRS) on how companies determine the extent to which they can distribute their profits to shareholders - which is a legal issue, not one that concerns the accounting standard-setters.

We are in the middle of a period of significant change in accounting standards, the rules by which companies prepare their accounts. However, while accounting standards focus on communicating performance to owners of the business, company accounts are also used for various other purposes in law, including determination of what is a realised profit and hence distributable to shareholders.

The biggest change in accounting relates to the move to IFRS in Europe, compulsory from this year for listed company group accounts. Listed and unlisted companies also have the option of switching the accounts of all subsidiaries and the parent company's own accounts to IFRS, and it is these that are used to calculate what dividends can be paid up the group and to the ultimate shareholders in the parent, not the group accounts. It has become apparent that companies taking up this option are finding that it can have severe adverse consequences for distributable profits, often creating dividend blocks, even though the overall financial position of the company in question has not changed. This is particularly so where a group has been acquisitive or undertaken group reorganisations.

The dividend block problem

Consider a situation in which a company buys a subsidiary for £100m and at the date of acquisition the subsidiary has distributable profits of £20m. If the subsidiary subsequently pays the £20m to its parent as a dividend (in cash for the purposes of this example), the parent may then want to distribute that profit in turn up to its own shareholders. Under UK accounting there is no problem: the parent records the receipt of the dividend as investment income, i.e. as a profit in its profit and loss account and, as long as the value of the subsidiary has not fallen below £100m as a result of the dividend payment (which would cause an impairment loss to arise), then the parent company can treat the receipt as a realised profit and pay the £20m out as a dividend to its own shareholders. Under IFRS, however, the situation is very different: IAS 27 requires any dividend paid out of a subsidiary's pre-acquisition profits to be treated as a reduction in the cost of the parent's investment in the subsidiary. In our example, the parent would have to reduce the cost of its investment in the subsidiary to £80m. As it has recorded no investment income and therefore no profit, it cannot under UK law have a realised profit and therefore cannot distribute the £20m on to its own shareholders, even though it has received £20m in cash.

Moreover, IFRS gives no exemption from restatement of a parent's investments in subsidiaries on transition, so a parent company will have to go back and work out which dividends were paid out of the subsidiaries' pre-acquisition profits and accordingly restate its holdings in those subsidiaries. In the above example, if the £20m had been paid out by the parent under its old UK GAAP accounts, that past distribution would not now be deemed illegal, but the restatement of the cost of investment in the subsidiary to £80m would create a deficit on the parent's distributable reserves of £20m. So this will be a particular difficulty for acquisitive companies, but it will also affect companies that have carried out any of various types of reorganisation, for example where the insertion of a new intermediate holding company has been achieved with the use of merger relief and so has been carried out at the book value of the underlying subsidiaries. The implementation of IAS 27 will mean going back to establish and record the fair value at the date of transaction, as well as working out the subsequent position in relation to dividends out of pre-acquisition profits (and of course in such situations the distributable profits of subsidiaries underneath the new intermediate holding company will have become pre-acquisition profits simply as a result of insertion of the new intermediate holding company).

Convergence of UK standards with IFRS

These potential dividend blocks, as well as the cost of obtaining the information to restate investments in subsidiaries, may stop companies switching to IFRS in their individual accounts, but there is no escape in the medium term 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. Moreover, some changes are coming in immediately, and nowhere is the impact more pronounced than in relation to pensions.

Pension deficits

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'. Those companies with significant deficits on their defined benefit pension schemes are finding that the deficit is eating into, and in some cases even wiping out, their distributable profits. (The equivalent international standard, IAS 19 'Employment Benefits' has a similar impact, although not necessarily quite so severe.)

There is some scope for restructuring to get round some of the problems, but importantly this may be restricted in relation to pensions because of recent pensions legislation and the creation of the Pension Protection Fund. 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 the 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.

The potential solutions

What action can companies take? It is vital that companies have an up-to-date picture of the impact of accounting changes on their distributable reserves. The bodies issuing guidance are the Institutes of Chartered Accountants and information can be found on the ICAEW website at www.icaew.co.uk. New draft guidance on the impact of IFRS on distributable profits has recently been published and is unlikely to be amended significantly before final publication.

On the IAS 27 transitional issue, i.e. the requirement to go back and restate investments in subsidiaries, potentially over many years' history, there has been lobbying of the IASB to give a cost/benefit exemption on the same grounds as others given in IFRS 1, the standard dealing with first-time application of IFRS. These lobbying efforts are continuing, but even if they reach fruition it is unlikely that an exemption would be available in time for 2005 year ends. In any case, although this might mitigate the cost of transition to IFRS and (as a side-effect really) help to some extent with the distributable profits problem, it will not deal with the distribution problem going forward for newly-acquired subsidiaries or new restructurings.

Ultimately, it is probably the law that will have to change, but this will take much longer than a change to an accounting standard. 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 strict link between the ability to distribute and company accounts. This will take some years; in the meantime, the DTI is being lobbied to relax the UK position for unlisted companies in UK law, which should be possible because the EU legislation only applies to listed companies.

Kathryn Cearns is the Consultant Accountant at City law firm Herbert Smith. The views expressed here are her own.