The Future of Audit Contents

3Capital maintenance


58.One of the central purposes of keeping accounts is to determine a company’s profits and how much of these are distributable in the form of dividends to shareholders. The laws that foster prudence in the payment of dividends and protect the company’s capital form what is known as the ‘capital maintenance regime’.

59.We received evidence that there is little compliance with and enforcement of the capital maintenance regime. For example, Sarasin & Partners LLP said that “key actors, including the audit firms, their regulator and even many investors, have lost sight of capital maintenance as a central purpose of accounts and audits.”126

60.Four examples illustrate the current confusion and poor practice in relation to capital maintenance and the payment of dividends:

61.Compliance with the capital maintenance regime is patchy at best and it is not adequately audited. We recommend that the FRC urgently reminds directors and auditors of their duties relating to the accounts and impose severe sanctions for breaches. Most importantly, auditors must be prepared to challenge management on their accounting of realised profits and distributable reserves.

The requirements

62.One of the reasons compliance may be poor is the lack of clarity over how the rules governing the payment of dividends are to be interpreted. Part 16 of the Companies Act 2006 sets out requirements for audited accounts, the appointment and removal of auditors, their functions and their liability. Section 495 says that the auditor’s report on the accounts “must state clearly whether, in the auditor’s opinion, the annual accounts give a true and fair view” and “have been prepared in accordance with the requirements of this Act”.

63.An important requirement of the Act is capital maintenance.133 Companies can only pay dividends out of past, realised profits available for distribution in the company’s ‘distributable’ reserves.134 Distributions to shareholders must be justified by reference to ‘relevant accounts’—normally the company’s last annual accounts.135

64.A company can only rely on its annual accounts to make a distribution if they have been “properly prepared” in accordance with the provisions of the Act.136 The auditors must have made their report on the accounts (unless the company is exempt from audit).137 If the auditor expresses a negative opinion on the accounts, a company cannot rely on its annual accounts to justify a distribution without a further opinion from the auditor on the effect of the matters at issue on the ability of the company to make a distribution.138

65.Distributions also need to be compatible with the fiduciary and other duties of directors:

Thus, directors should consider both the immediate cash flow implications of a distribution and the continuing ability of the company to pay its debts as they fall due. In reaching their decision they must take into account any change in the financial position of the company after the balance sheet date of the relevant accounts and the future cash needs of the company.139

66.We explore below the discrepancies that have been created by accounting standards evolving away from the letter and spirit of the law.

The accounting standards and the law

67.The FRC is responsible for issuing accounting standards in the UK,140 but the international financial reporting standards (“IAS” and “IFRS”) that most large companies use141 are set by the International Accounting Standards Board (IASB) of the IFRS Foundation. As of April 2018, 144 jurisdictions require IFRS Standards for all or most listed companies, including EU countries. The major exception is the United States, which uses its own national standards.142 Although international standards do not have any direct impact on national accounting requirements, they often influence their development and result in a convergence of national rules.

68.In submissions to the audit market study, the CMA received views that the current audit framework and accounting standards are failing to deliver a key purpose of audit: assessing whether the company’s capital is properly protected, as required by the capital maintenance regime. The CMA summarised these views as follows:

Because accounts are prepared in accordance with accounting standards, and auditors review the accounts against these standards, the Companies Act 2006 requirements are not necessarily met—a case of company law following the standards, rather than the other way around. As a result, a key purpose of the audit report is lost. [ … ]

This particular submission on the purpose of audit has been subject to significant legal analysis in recent years. It seems unsatisfactory that what appears to be quite a fundamental question about the purpose of an audit as required by the Companies Act 2006 can be subject to such debate and difference in legal opinion. We are supportive of a review which examines this debate in detail and resolves in certain terms what the purpose of audit is.143

69.We agree with the CMA that this is an utterly unsatisfactory situation. In their evidence to us, Sarasin & Partners LLP argued that profits should be broken down in the accounts between realised and unrealised, and reserves between distributable and undistributable. They also called on the Government to own the guidance for calculating what counts as realised profits, arguing that accrued income should not be treated as realised. Instead, realised profits should be those that are realised in cash or near cash.144 A number of auditors supported this simple and prudent definition of realised profits in private conversations.

70.Sarasin explained how the law was gradually conflated with the new accounting standards, the IFRS (International Financial Reporting Standards):

With the introduction of IFRS, the industry lobbied the authorities to reduce the ‘complexity’ in the calculation of distributable reserves (an aspect of Company Law, which they described as “outdated” and “flawed”) by expanding the definition of what could be treated as “realised” profits to include the profits recognised by IFRS.

The result is that the Guidance explicitly states that accrued income can be treated as realised for the purposes of distribution. This not only flies in the face of common sense (accrued income is by definition not realised as cash), but runs contrary to the purpose of capital protection. If directors are permitted to distribute income that they expect to receive, then there are significant risks that in the event that the expected income never materialises, dividends could be paid out of capital, thereby directly contravening company law.145

71.A 2005 paper by the Institute of Chartered Accountants in England and Wales (ICAEW, the body responsible for producing the Guidance referred to by Sarasin above) outlined how IFRS is not aligned with the law. It explained that the transition to IFRS was creating “serious concerns” and “many issues” about the lawful payment of dividends under the capital maintenance regime. And yet, ICAEW did not side with the law, arguing instead that the rules were flawed and needed to be adapted to IFRS:

The [capital maintenance] regime imposes a rigid link between company balance sheets and the amount of company distributions and, especially with the introduction of IFRS, is becoming increasingly flawed. [ … ]

It is necessary to break this traditional link between accounting profit and dividends.146

72.In oral evidence, Scott Knight from BDO agreed that “the financial reporting standards that include fair values create profits that are not realised”, and so not distributable under the law.147 Being more explicit, Jac Berry from Mazars was very clear that the standards do not deliver the law. She said that part of the auditor’s role is to make sure that companies adhere to relevant laws and regulations.148

73.In oral evidence there was some confusion among the Big Four on this issue. The heads of KPMG and EY explicitly said they thought the standards delivered the law, and the head of Deloitte agreed with them.149 The head of PwC said he was not an auditor, but generally trusted that his firm complied with whatever the law was.150

74.It is clear that the law needs both clarifying and tightening. One crucial gap concerns the definition of realised profits. The Companies Act 2006 states that “realised profits” and “realised losses” are such profits or losses “to be treated as realised in accordance with principles generally accepted [ … ] with respect to the determination for accounting purposes of realised profits or losses”.151 The problem here is that the concept of realisation does not inform the recognition of profits in IFRS—a clear indication that the accounting standards have not been designed to be in line with the purpose of the law. In the words of ICAEW, “accounts, especially under IFRS, are becoming less and less driven by realisation.”152 The mismatch between the international standards and the law is not surprising. The IFRS, whose purpose is to provide international comparability, “cannot reflect in detail specific requirements of the multitude of different capital maintenance regimes among the more than 140 jurisdictions that now require the use of our Standards”.153

75.This discrepancy is one reason why the ICAEW’s Guidance on realised and distributable profits under the Companies Act 2006 runs to 173 pages. This guidance was written by the industry to bridge the gap but was not vetted by government lawyers.154 Instead of resolving the issue, the FRC spent the best part of a decade fighting the concerns of a range of major institutional stakeholders about the flaws in IFRS and ICAEW’s interpretation of the law.155 A battle of legal Opinions ensued between eminent QCs.156 It is surprising that four conflicting Opinions did not trigger a deeper investigation by the Government and the FRC. The industry needs clarity.157

76.The House of Lords became involved in 2016. Lord Hollick (Chairman of the Economic Affairs Committee) wrote to the Chief Executive of the FRC, Stephen Haddrill, to ask him what the FRC was doing to address these legal questions,158 but ultimately no further action was taken. In response to parliamentary questions in that House, the Government explained that it was content that the FRC accepted the legal advice it had received.159

77.In oral evidence, BEIS permanent secretary Alex Chisholm said that the 170-page ICAEW guidance was part of the problem and needed to be simplified.160 Secretary of State Greg Clark welcomed our and Brydon’s interest in these issues, and reassured us that it was not in any way his intention to weaken the regime.161

78.We are alarmed and disappointed that the FRC has not provided clarity on these fundamental issues, given the potential and actual problems that have arisen. The Government and the FRC should work together to resolve these issues as soon as possible, and produce simple and prudent guidance for companies and auditors to follow.

79.We recommend that the Government and the FRC urgently produce a clear, simple and prudent definition of what counts as realised profits for the purpose of distributions. We support defining realised profits as realised in cash or near cash.

80.We reject any legislative change the aim of which is to adapt the law to the accounting standards. Instead, auditors and directors need to be reminded that compliance with the accounting standards does not fulfil all legal obligations, and that the law comes first. We regret that the FRC has failed to clarify this basic point with those it regulates. We recommend that the FRC and its successor vigorously enforce the revised capital maintenance regime.


81.The Government has agreed that something needs to be done about capital maintenance. A BEIS consultation on corporate governance and insolvency included proposals to strengthen the UK’s dividend regime. In its response (August 2018) to the consultation, the Government said it would consider tightening one of the key capital maintenance rules known as the ‘net assets test’.162 The Companies Act 2006 prohibits companies from paying dividends that would bring the company’s net assets (assets minus liabilities) to a level lower than the sum of the company’s paid-in capital and undistributable reserves.163 In short, dividends cannot be paid out of the capital invested by shareholders.

82.The problem with the net assets test is again one of interaction between the law and accounting standards (IFRS in particular). The net assets test is only as prudent as the underlying accounting. If accounting standards become less conservative (as IFRS did by abandoning the principle of prudence in favour of ‘neutrality’),164 so does the test.

83.The treatment of goodwill illustrates the impact that accounting standards can have on the level of prudence in the accounts, and therefore the prudence of distributions. Goodwill is the amount a company pays for an acquisition over and above the fair net value of the assets acquired. For example, if a company bought a very popular restaurant, it would pay a lot more than the value of the restaurant’s assets (e.g. kitchenware, tables, chairs, etc), because the company is buying a popular brand with a large client base and the expectation of future profits.

84.It used to be a requirement for goodwill to be “amortised” every year.165 Companies would gradually reduce the value of the goodwill by charging themselves a notional expense known as amortisation. The expense may be notional, but it has the real effect of reducing accounted profits, and so reducing the funds available for distributions.

85.When accounting standards were changed in 2005, the requirement to amortise goodwill every year was dropped.166 Instead, goodwill now has to be “tested for impairment”, meaning that management checks whether goodwill is still worth what it was the year before. If it is not, it is “impaired” (the value is reduced). This is the reason that Carillion was able to keep the value of its goodwill entirely unchanged in the five years to 2017 (despite strong evidence that it should have been impaired).167 The auditor did not successfully challenge management’s assessment of the value of goodwill. It is welcome that the Government proposed requiring companies and auditors to take a more critical look at the valuation of goodwill for the purpose of distributions.168

86.We strongly support the Government’s proposal to require companies and auditors to take a more critical look at the valuation of goodwill for the purpose of distributions. We recommend that the Government urgently take steps to tighten the net assets test.


87.At its heart, the divergence between IFRS and the law is that the overriding principle behind IFRS is neutrality, whereas the overriding principle behind the law is prudence.169 The two can be wildly different at times, as exemplified by Carillion. We cannot unilaterally reform the international standards, but we can ensure that prudence remains at the heart of the law. Prudence leaves companies better capitalised, and so more resilient to shocks.

88.Prudence is fundamental to good accounting and underpins a key purpose financial statements, showing the amount of profit that is available for distribution. In short, prudent accounting means recognising losses and liabilities earlier than gains and assets. It is synonymous with being cautious or conservative. The European Financial Reporting Advisory Group explains that central role of prudence in good financial reporting “reflects the use of financial statements in showing the amount of profit that is available for distribution”. They define the essence of prudence as ensuring that “assets and income are not overstated and that liabilities and expenses are not understated”, and so gains are reported only if they are highly probable or reasonably certain (often not until realised) whereas (expected) losses are recognised as soon as they are identified. Therefore, prudence treats assets and liabilities asymmetrically, requiring “a higher degree of certainty before recognition of assets than of liabilities”.170

89.For auditors, challenging management when the letter of the standard permits optimistic accounting is difficult. Without a clear breach of the rules, the auditor in practice will probably give management the benefit of the doubt. By contrast, it is much easier to challenge imprudent accounting when prudence is embedded in the standards or the law.

90.The Government cannot unilaterally change the international accounting standards, but it can seek to tighten the law. Stopping imprudent distributions makes companies more resilient and encourages management to think longer term and tackle problems earlier. The principle of prudence should be made explicit in the law and its interpretation.

91.The Government and the FRC should lead international efforts to improve accounting standards. If the Government wants to achieve its ambitions of a Global Britain advancing UK influence and interests, then it should be prepared to spell out how it wants to lead international standards on key sectors such as accounting and audit.


92.Every witness we asked agreed that companies should be required to disclose the balance of distributable reserves in the annual accounts, and break down profits between realised and unrealised.171 This proposal was also made by the Government in its response to the consultation on Insolvency and Corporate Governance.172

93.There are two good reasons to require disclosure. First, reporting on the application of capital maintenance rules makes it more likely that they will be complied with in the first place and, if necessary, enforced. Second, the information will be very useful to investors, who “need to understand better what the quality of profits are”.173 We recommend that companies be required to disclose the balance of distributable reserves in the annual accounts and break down profits between realised and unrealised.

Solvency-based system

94.The consultation on Insolvency and Corporate Governance also “explore the case for a comprehensive review of the UK’s dividend regime and more significant change such as considering the merits of a solvency-based system”.174 A solvency-based system is one where dividends can be paid only when the board is satisfied (and makes a statement to that effect) that the company will, after the payment of the dividend, still be able to pay its debts as they become due in the normal course of business. Key advantages of this system are said to be its greater simplicity and stronger protection for creditors. A number of non-EU countries took this approach, such as the US, Canada, Australia and New Zealand.175 Some respondents to the BEIS Insolvency consultation argued in favour of adopting a similar system in the UK.

95.There is no incompatibility between capital maintenance rules and a solvency-based system–the two systems can be combined. Indeed, solvency-based systems are usually allied with net assets tests such as that in the capital maintenance regime discussed earlier. We also note that similar solvency requirements already exist in the UK regime under the fiduciary duties of directors,176 but there is little enforcing of these duties and no reporting. Moving to a formalised solvency system would bring these duties to the forefront of directors’ minds. ICAEW described moving to a solvency-based system as a “radical” reform,177 but they are not against it in principle and they agree that the current capital maintenance regime is “not fit for purpose”.178

96.A solvency system should complement the revised capital maintenance regime that we recommend, not replace it. We recommend that the Government adopts a complementary solvency-based system in which directors must state that dividend payments will not make the company insolvent or create cashflow problems.

126 Sarasin & Partners LLP (FOA0024).

127 Domino’s Pizza, Annual Report & Accounts 2016, p 71.

128 FT, Carillion PLC CLLN:LSE equity data [accessed 20 March 2019].

129 Carillion, 2017 first-half trading update, (10 July 2017).

130 House of Commons Library, The collapse of Carillion, (March 2018), p 19.

131 Capita, Cash flow statement for the year ended 31 December 2017, in: Annual Report 2017, (23 April 2018), p 95; and: Capita, Update on Capita’s transformation and outlook, (31 January 2018).

132 High Court Approved Judgement, [2019] EWHC 150 (Comm), p 27.

133 Part 23 Distributions.

134 Section 830 and 831.

135 Sections 836–839.

136 Section 837(2).

137 Section 837(3).

138 837(4)(a).

140 FRC, Roles and Responsibilities, (June 2017), p 4.

141 All listed companies in the EU must use IAS/IFRS for group accounts. Member states can permit or require the use of IAS/IFRS for individual company accounts and unlisted groups. Regulation (EC) No 1606/2002 of 19 July 2002 on the application of international accounting standards, Articles 4 and 5.

142 IFRS, Analysis of the IFRS jurisdiction profiles, (updated 25 April 2018).

144 Sarasin & Partners LLP (FOA0024). Near cash refers to assets that can readily be converted into cash.

145 Sarasin & Partners LLP (FOA0024).

146 ICAEW Briefing Paper, Implications of IFRS for Distributable Profits, (July 2005).

151 Section 853(4)

152 ICAEW Briefing Paper, Implications of IFRS for Distributable Profits, (July 2005).

154 Sarasin & Partners LLP (FOA0024).

155 The Universities Superannuation Scheme Investment Management (USSIM), the Local Authority Pension Fund Forum (LAPFF), Colombia Threadneedle and the UK Shareholders’ Association (UKSA) sought legal opinions from George Bompas QC on this question.

156 George Bompas QC argued that IFRS cannot be relied upon to meet the statutory true and fair view requirement for accounts and that the FRC guidance and legal advice it relied on are defective. [In: George Bompas QC, International Financial Reporting Standards (Issues arising in relation to the Companies Act 2006): Opinion, (March 2013); and: Further Opinion, (August 2015). In response, the FRC asked Martin Moore QC, who had provided the initial Opinion that Bompas considered to be flawed, and who also advised the ICAEW on their guidance, to provide a second Opinion. [See: Martin Moore’s page in Erskine Chambers website for ICAEW work [accessed 13 March 2019]; and for the Opinions: FRC, True and Fair, June 2014, p 1.]

157 We note that the Independent Non-Executives of KPMG wrote in their report that they “raised these issues with the FRC, asking for further work [to] be done by them to explore whether accounting rules might be used in a way that was against the public interest (e.g. are there areas where current rules might allow early declaration of profits, which in turn could encourage reckless behaviour by investors and lead to the over statement of company solvency). […] We are concerned that there is no programme in place that would aim to give better assurance on this issue.” In: KPMG, UK Transparency Report 2018, (December 2018), p 59.

163 Section 831

164 FRC, True and Fair, (June 2014), pp 1–2.

165 IAS Plus, IAS 22—Business Combinations (Superseded), [visited 21 August 2018].

166 See: IAS Plus, Goodwill and impairment project - Agenda paper 18, (16 February 2016).

169 FRC, True and Fair, (June 2014), pp 1–2.

170 European Financial Reporting Advisory Group, Getting a Better Framework: Prudence, (April 2013), p 4.

171 E.g.: Q63, Q614–615.

173 Q63 (Leon Kamhi, Head of Responsible Investment, Hermes Investment Management).

177 ICAEW, Distributable profits and business failures (briefing note for the Committee), (June 2018).

Published: 2 April 2019