What it means
Company law protects creditors by stopping owners from draining a business of its funds. A company may therefore pay dividends only from profits that are properly available, not from its share capital or from gains that exist only on paper.
The test looks at the whole history of the company, not just this year. In the United Kingdom and many other countries following similar rules, the basic idea is that distributable profits equal accumulated realised profits minus accumulated realised losses.
Realised means the gain has turned into cash or something close to it, or has been recognised under established accounting practice as realised. An unrealised increase in the value of a property, for example, usually does not count.
This means a company can report a profit in the current year and still be unable to pay a dividend. If it has large losses brought forward from earlier years, those must be cleared first.
The reverse can also be true, with a loss-making year in which the company still has enough past profits to pay a dividend. Public companies face an extra test in some jurisdictions.
They may also need to show that, after the dividend, their net assets remain above the total of called-up share capital and undistributable reserves. These additional rules aim to prevent a listed company from weakening its capital base.
Directors are responsible for checking the position before declaring a dividend. If a dividend is paid unlawfully, shareholders who knew about it may have to return it, and directors can face personal liability.
Many boards ask for a written check from the finance team, based on recent accounts, before any payment is approved. Timing and documentation matter in practice.
The relevant accounts are usually the last annual accounts, or interim accounts prepared specifically for the purpose if the year-end figures are out of date. Keeping a short signed note of the calculation on file protects the directors if the payment is questioned later.
In practice
Real-world examples
Example 1
A family-owned engineering company wants to pay a $500,000 dividend. The finance manager reviews the latest accounts and confirms that distributable profits are $720,000, so the dividend can go ahead lawfully. He files a one-page note of the calculation with the board minutes.
Example 2
A retailer had a loss of $2,000,000 two years ago and profits of $600,000 in each of the last two years. Although recent trading is strong, the accumulated position is still a deficit of $800,000, so no dividend can be paid.
Example 3
A property company's accounts show a large profit, but $3,000,000 of it comes from a rise in the value of its buildings. The directors can pay dividends only from the realised part and limit the payout to $1,100,000. The balance of the profit stays in the company until the properties are actually sold.
Think of it
Imagine a household budget. Your total net worth includes your house and car, but your distributable profit is simply the spare cash left in your savings account after paying your mortgage, bills, and grocery shopping for the month.
Formula
Calculation
Distributable profits = Accumulated realised profits - Accumulated realised losses
Suppose a company has accumulated realised profits of $1,200,000 and accumulated realised losses of $300,000. It also holds a revaluation surplus of $400,000 on a property, which is unrealised and so excluded. Distributable profits = 1,200,000 - 300,000 = $900,000. The directors may declare dividends up to $900,000, and not the $1,300,000 that would result if the revaluation surplus were wrongly included.Case study
Seen in the real world
Cobbleston Brewing is an illustrative, fictional company whose owners expected a $400,000 dividend after a record year. The profit and loss account showed a profit of $650,000, so the shareholders assumed that there was enough to pay.
The finance director checked the position before the board meeting and found accumulated losses of $350,000 from an earlier plant expansion that had gone badly. Distributable profits were therefore 650,000 - 350,000 = $300,000, not $650,000.
The board reduced the dividend to $250,000, leaving a small buffer. The illustrative lesson was that the profit of the latest year is only part of the legal test, and the shareholders were happy to be told before the payment was made rather than afterwards. The finance director also began producing a one-line distributable profits figure with every set of quarterly accounts.
Watch out
Common mistakes
- Assuming that this year's profit is the amount available for dividends, when earlier losses and unrealised gains also matter.
- Including revaluation gains or other unrealised amounts in the calculation, which overstates what can lawfully be paid.
- Checking the position only at the year end, when the test is normally applied using recent accounts at the time the dividend is declared.
Questions
People also ask
Can a company pay a dividend when it has made a loss this year?
Yes, provided it still has enough accumulated distributable profits from earlier years to cover the payment.
Who is responsible for checking?
The directors are responsible, usually relying on the finance team and, for larger payments, on advice from the auditor or a legal adviser.
What happens if a dividend is unlawful?
The company may be able to recover it from shareholders who knew about the problem, and the directors may be personally liable.