What it means
Creditors lend to a company on the strength of its capital, and the law protects them by preventing shareholders from taking that capital back out as dividends. The mechanism varies.
Many jurisdictions, including the United Kingdom and much of the Commonwealth, use a realised profits test: a company may distribute only its accumulated realised profits, so far as not previously distributed or capitalised, less its accumulated realised losses. Others, including many United States states, use a solvency test: a distribution is lawful if, after it, the company can pay its debts as they fall due and its assets exceed its liabilities.
Some use both. Public companies often face an additional net assets test, under which net assets after the dividend must not fall below called-up share capital plus undistributable reserves.
Whatever the test, the calculation is made for the company paying the dividend, on its own accounts, not for the group. The realised profits test turns on what "realised" means.
A profit is realised when it has been converted into cash or an asset that is readily convertible into cash, or, under accounting guidance in most jurisdictions, when it is recognised in accordance with accounting standards and the relevant asset is reasonably certain of being turned into cash. Trading profits are realised; revaluation gains on property or investments held are generally not, until the asset is sold; unrealised gains on financial instruments measured at fair value may or may not be, depending on how readily convertible they are.
Losses, by contrast, are treated as realised more readily, including impairments and provisions. The result is that distributable earnings are often lower than retained earnings in the balance sheet, because retained earnings include unrealised gains and because some reserves are undistributable by law.
The group question is the one that most often catches directors out. A parent company's consolidated accounts may show large retained earnings, but those earnings belong to the subsidiaries that made them, and the parent can only distribute its own profits: mainly the dividends it has received from subsidiaries and its own investment income, less its own costs and any impairment of its investments in subsidiaries.
A parent whose subsidiaries have not paid dividends up to it, or whose investment in a subsidiary has been written down, may have little or nothing it can distribute, however profitable the group. The remedy is for the subsidiaries to declare dividends to the parent first, which requires each of them to have distributable earnings of its own, and then for the parent to distribute.
The accounts used matter too. A distribution must be justified by reference to the last annual accounts, or by interim accounts if those do not show sufficient distributable earnings, or by initial accounts for a newly formed company.
Public companies may have to file the interim accounts. Directors who declare a dividend on the basis of management figures that turn out to be wrong, or who ignore losses that have arisen since the last accounts, are at risk.
In solvency-test jurisdictions, the board must form and usually document a view that the company will remain solvent after the payment, which requires a forward-looking assessment of cash flows and liabilities, not just a reading of the balance sheet. The consequences of getting it wrong are serious.
An unlawful dividend is void; shareholders who knew or ought to have known that it was unlawful must repay it; and directors who authorised it are personally liable to the company for the amount, whether or not they benefited, a liability that liquidators pursue. The term distributable earnings is also used, with a different meaning, by real estate investment trusts, business development companies and some investment funds to describe a non-statutory measure of the cash earnings available for distribution, typically net investment income plus realised gains, which is used to set their dividends and which investors compare with the amounts paid; that usage is a performance measure, not a legal limit.
In practice
Real-world examples.
Example
A company with retained earnings of $9,000,000 and an unsold property revaluation gain of $6,000,000 in that figure has distributable earnings of $3,000,000, and its planned $4,000,000 dividend is reduced.
Example
A holding company with $50,000,000 of consolidated retained earnings but negative reserves of its own after writing down a failed subsidiary cannot pay a dividend until its operating subsidiaries pay dividends up to it.
Example
A real estate investment trust reports distributable earnings of $2.10 a share, being net rental income plus realised gains and less certain adjustments, and pays a dividend of $2.00, a 95% payout of that measure.
Think of it
“Distributable earnings are profits that can actually be paid out-after all restrictions are considered.
Formula
Calculation
Distributable earnings (realised profits test) = Accumulated realised profits minus Accumulated realised losses minus Amounts previously distributed or capitalised
Retained earnings minus Unrealised gains included in them minus Undistributable reserves = an approximation of distributable earnings
Public company net assets test: Net assets after the distribution must be at least Called-up share capital + Undistributable reserves
Solvency test: after the distribution, Assets exceed Liabilities and the company can pay its debts as they fall due
Group: Parent's distributable earnings are calculated from the parent's own accounts, not the consolidated accounts
Worked example: an individual company. A company's balance sheet shows retained earnings of $4,000,000. Included in that figure is a $1,500,000 gain on revaluing its investment property, which has not been sold. The company also has a share premium account of $2,000,000, which is undistributable by law.
- Distributable earnings = $4,000,000 minus $1,500,000 (unrealised) = $2,500,000; the share premium is excluded from the calculation
- A proposed dividend of $1,000,000 is within the limit. A proposed dividend of $3,000,000 would be unlawful by $500,000 even though retained earnings appear to cover it
- If the company were a public company with share capital of $5,000,000 and net assets of $11,000,000, the net assets test would require net assets after the dividend of at least $5,000,000 + $2,000,000 (share premium) + $1,500,000 (revaluation reserve) = $8,500,000; a $1,000,000 dividend leaves $10,000,000, so the test is met
Worked example: a group. A parent company's consolidated balance sheet shows retained earnings of $20,000,000. The parent's own balance sheet shows retained earnings of $3,000,000, because its subsidiaries have retained most of their profits and the parent's income has been limited to modest dividends from them.
- The parent can distribute at most $3,000,000, regardless of the consolidated figure
- To pay a $6,000,000 dividend, the subsidiaries must first declare dividends to the parent of at least $3,000,000, each within its own distributable earnings; only then does the parent have $6,000,000 to distribute
- If the parent had impaired its investment in a subsidiary by $4,000,000 during the year, its own retained earnings would be minus $1,000,000 and no dividend could be paid until the deficit was made goodCase study
Seen in the real world.
A listed group had paid a steady dividend for a decade, and the board approved the usual final dividend of $6,000,000 on the strength of consolidated retained earnings of $22,000,000 and a consolidated profit for the year of $8,000,000. The finance director, newly appointed, checked the parent company's own balance sheet before the dividend was paid and found a problem. The parent's own retained earnings were $2,500,000.
The group's profits were made in three operating subsidiaries, which had paid modest dividends to the parent over the years but had retained most of their earnings, and in the year just ended the parent had written down its investment in a fourth subsidiary, which had been closed, by $5,000,000. The parent's realised profits were $2,500,000; the proposed dividend was unlawful by $3,500,000.
The board had two options. It could reduce the dividend to $2,500,000, which would have been read by the market as a signal of distress and would have broken the group's dividend record. Or it could arrange for the operating subsidiaries to declare dividends to the parent before the parent's dividend was paid.
Each subsidiary's own distributable earnings were checked: they were ample, at $6,000,000, $5,000,000 and $4,000,000, and none was subject to banking covenants that restricted dividends. The subsidiaries' boards declared dividends to the parent totalling $4,000,000, which the parent received as realised profit, raising its distributable earnings to $6,500,000.
The parent's dividend of $6,000,000 was then lawful, and it was paid on the original timetable. The subsidiary dividends were paid in cash where the subsidiaries had it and by intercompany settlement where they did not.
The finance director's report to the board made three recommendations, all adopted. First, the parent's own distributable earnings, not the consolidated figure, would be shown in every dividend paper. Second, the subsidiaries would pay dividends to the parent each year in the ordinary course, so that the parent's reserves tracked the group's profits and the annual dividend never depended on a last-minute cascade.
Third, any impairment of an investment in a subsidiary would be flagged to the board for its effect on distributable earnings at the time it was recognised, not discovered at the dividend date. The chairman's comment was that the board had come within a fortnight of an unlawful dividend that would have exposed every director to personal liability, and that the consolidated accounts, which the board had relied on for ten years, had never been the right document.
Watch out
Common mistakes.
- Paying a parent company dividend on the strength of consolidated retained earnings, when only the parent's own realised profits are distributable.
- Treating retained earnings as distributable without removing unrealised gains, such as unsold revaluations, and without checking for reserves that the law makes undistributable.
- Declaring a dividend on management accounts or on old annual accounts without checking whether losses since then, including impairments, have reduced distributable earnings.
Questions
People also ask.
What is the difference between distributable earnings and retained earnings?
Retained earnings is an accounting figure, the accumulated profits not yet distributed, and may include unrealised gains. Distributable earnings is a legal figure, the profits the company may lawfully pay out, which excludes unrealised gains and undistributable reserves and is calculated for the individual company. Distributable earnings are usually lower.
Can a company pay a dividend if it has cash?
Only if it also has distributable earnings. Cash is necessary to pay a dividend but not sufficient to make it lawful; a company with cash from borrowing or from selling assets at book value may have no distributable earnings, and a company with distributable earnings may have no cash.
What happens if a dividend exceeds distributable earnings?
It is unlawful. Shareholders who knew or should have known must repay it, and the directors who approved it are personally liable to the company for the excess, a liability that a liquidator will pursue if the company later fails.
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