Dividends and Reportable Irregularities
In today's complex financial landscape, understanding the nuances of dividend distribution and the critical role of independent reviews is essential for maintaining a company's financial health.
This article delves into the intricacies of dividends, their legal and regulatory frameworks, and how accountants, especially when acting as independent reviewers, play a pivotal role in safeguarding a company against financial mismanagement and insolvency.
We will explore how dividends are handled, the importance of solvency and liquidity tests, and the responsibilities entailed in managing reportable irregularities.
Let's begin by exploring the foundational concept of dividends and their impact on shareholder value.
What are dividends
Shareholders often expect to receive dividends as a return on their investment in a company, but it's important to note that this expectation does not equate to a guaranteed right. Dividend distributions are at the discretion of the company’s board and depend on various factors including profitability and financial needs. While shareholders invest capital into the company, they do not have the right to withdraw their initial contributions during the company’s operation.
Are dividends paid from profits or cash?
Historically, a dividend was understood to be a share of a company’s profits distributed evenly among its shareholders based on their ownership percentage. This traditional definition saw dividends strictly as a division of profits.
However, this concept has evolved significantly under modern corporate law.
Before changes to the Section 90 of the Companies Act, 61 of 1973 in 1999, companies could only distribute dividends out of their profits.
This rule was part of what was known as the capital maintenance regime, ensuring that a company's capital was preserved. But with the introduction of the Companies Act, particularly from June 30, 1999, this approach shifted towards a focus on liquidity and solvency. This has continued in Section 4 of the Companies Act, 2008.
Now, dividends are not solely tied to profits.
The Companies Act has broadened the definition to include distributions that don’t necessarily come from profits. The key requirement is that any distribution—whether from profits or capital—must not compromise the company’s ability to pay its debts as they come due or its overall financial health. This is assessed through what's called the solvency and liquidity test.
For accountants, this change means that when preparing financial statements or advising on dividends, they must consider more than just the company's current profits.
They need to evaluate the overall financial stability of the company to ensure it can still meet its obligations after any dividends are paid. This modern approach allows more flexibility in managing shareholder returns but also requires careful financial oversight to prevent jeopardizing the company’s financial standing.
Having established what dividends are, it's crucial to understand the legal framework that governs their distribution.
How to decide if a dividend can be paid
Legal requirements for distributions
Before a company can make distribution to shareholders, whether as dividends or other forms of value, it must adhere to certain conditions:
Legal Obligations and Court Orders: A company should not proceed with a distribution unless it is part of an existing legal obligation or has been authorized by a court order. It's crucial for the board to have formally approved the distribution.
Board Authorization and Financial Tests: The board must conduct and pass a solvency and liquidity test, confirming that the company will remain solvent and liquid immediately after the distribution. This ensures that the company can still meet its debts as they become due for the next 12 months.
Broad definition of distributions
Distributions are broadly defined under the act to encompass more than just traditional cash dividends:
Variety of Forms: Distributions includes cash, and transfers of assets, incurring or forgiving debts, and waiving obligations. This broad definition ensures that all forms of value transfers are covered under the company’s dividend policies..
Beyond Direct Shareholders: Distributions are not limited to direct shareholders; they can also reach holders of a beneficial interest. This includes non-shareholders or entities within the same corporate group, ensuring that distributions that constitute dividends are recognized as such, regardless of the recipient’s official shareholder status.
Understanding the solvency and liquidity test
Before a distribution can be authorized, the board must conduct a solvency and liquidity test to ensure that the company will not find itself in financial jeopardy immediately after the distribution.
This test, detailed in Section 4 of the Companies Act, involves key criteria:
Asset-Liability Assessment (Factual insolvency)
The company’s assets, when fairly valued, should equal or exceed its liabilities. This valuation includes considering all reasonably foreseeable financial circumstances and contingent liabilities that might affect the company's financial health.
Debt Repayment Ability (Commercial insolvency)
The company must be able to pay its debts as they become due in the ordinary course of business for the next 12 months after the test is conducted or after the distribution is made. Even if the company has assets, if it can't access them quickly enough to pay upcoming bills, it's commercially insolvent.
Board’s Resolution and Acknowledgment
After performing the solvency and liquidity test, the board must formally acknowledge, through a resolution, that:
The test has been applied.
The company meets the conditions of the test immediately following the proposed distribution.
Fair and Reasonable Valuation
The solvency and liquidity test requires a fair valuation of the company’s assets and liabilities. In determining fair valuation the board must rely on:
Accurate accounting records that meet the requirements of Section 28.
Financial statements that comply with Section 29, these may include financial statements prepared using IFRS, IFRS for SME or an accounting policy as appropriate to the business of the entity.
Fair valuation of assets and liabilities:
Valuing assets is not an exact science and can vary widely depending on who is doing the valuation and their approach. This subjectivity can significantly affect the outcome of a solvency test, which checks if a company can pay its debts. If directors get this wrong, they can be held responsible unless they've taken careful steps to ensure the valuation was accurate.
Directors have a critical role in ensuring these asset valuations are accurate. If they hire a well-regarded valuer and there's no apparent reason to question the valuation's accuracy, they're generally protected from being held liable if something goes wrong.
However, there are times when directors may choose not to use external valuers and instead rely on their own expertise. This could be beneficial if directors have specific knowledge about the industry or particular assets that might give them a deeper insight than an external valuer. For example, understanding current industry trends could help directors more accurately determine if an asset is becoming obsolete. In such cases, directors are expected to use their own reasonable skills and judgment to assess the value of assets, ensuring that their internal assessments are sound and reliable.
Any other reasonable valuations under the circumstances, which may include forecasts and projections of the company’s future revenue streams and expenses.
Contingent Assets and Liabilities
In evaluating the company's financial standing, the board must consider not only the current but also the reasonably foreseeable contingent assets and liabilities. This comprehensive approach ensures that the company is not only solvent on paper but also equipped to handle potential financial uncertainties.
Contingent assets: A contingent asset is a potential asset that may arise if a certain event occurs in the future.
They are not recognised as an actual asset in financial statements until it is virtually certain that the inflow of economic benefits will occur. This conservatism ensures that financial statements do not overstate the financial position of a company. These assets are not recognized on the balance sheet initially because their realisation is not certain. They are usually disclosed in the notes to the financial statements if it is probable that the benefits will flow to the company.
However in determining the fair valuation of asset section 4 allows that the directors to also consider contingent assets.
Examples of Contingent Assets:
A company has a court case pending where it might receive a financial settlement.
The expected proceeds from a lawsuit, if the company is likely to win.
Possible receipt of government grants that are yet to be approved.
Contingent liabilities: A contingent liability is a potential liability that may become an actual liability when one or more future events occur or fail to occur. As with contingent assets, the likelihood of occurrence can be uncertain. The accounting treatment requires that a contingent liability is recorded in the financial statements only if it is probable that the liability will occur and the amount can be reasonably estimated. Contingent liabilities are typically disclosed in the financial notes unless the likelihood of occurrence is high and the amounts can be reasonably estimated, in which case they must be recorded on the balance sheet.
Examples of Contingent Liabilities:
Guarantees provided to other parties, where you might need to fulfill the guarantee if the third party defaults.
Pending lawsuits where a company may have to pay damages if the case is lost.
Environmental cleanup obligations that will only be enforced upon the company if certain regulations are enacted.
Implications of Non-Compliance
Failing to adhere to these statutory requirements can have significant consequences:
Personal Liability of Directors: If distributions are made without proper authorization or without ensuring solvency and liquidity post-distribution, directors may be held personally liable.
Legal Repercussions: Unlawful distributions can lead to legal actions against the company and its directors, potentially resulting in fines and penalties.
By fulfilling these obligations, the board not only acts in compliance with the law but also in the best interest of the company and its stakeholders, ensuring that the company remains robust and capable of meeting its future financial obligations. This detailed and cautious approach underpins the integrity and sustainability of financial practices within the corporate sector.
Financial statements and fair valuation
Financial statements are drafted within the framework set by the entities accounting policies. Accounting policies determines the type of financial reporting standard or framework used to recognise, measure, present and disclose the information in the financial statements. Financial statements may be prepared using IFRS, IFRS for SME, or accounting policies as appropriate to the business for example: modified IFRS for SME, modified cash basis of accounting, or tax basis of accounting.
The choice of accounting method a company uses to prepare its financial statements can significantly impact the reported values, including the net profit or loss. This means that the same company can show dramatically different profit amounts depending on whether it uses International Financial Reporting Standards (IFRS) or a modified cash basis of accounting.
Here are some of the key reasons for these differences:
Recognition of Revenue and Expenses
IFRS: Under IFRS, revenue and expenses are recognized based on the accrual principle. This means that income and expenses are recognized when they are earned or incurred, regardless of when cash transactions occur. This approach reflects economic events more accurately.
Modified Cash Basis: This approach records revenues when cash is received and expenses when cash is paid, with certain adjustments for items like receivables and payables. This method does not fully capture all the economic activities of a business as accurately as IFRS because it is partly based on cash flow.
Treatment of Receivables and Payables
IFRS: Accounts receivable and payable are fully recognized, affecting the net income and subsequently retained earnings.
Modified Cash Basis: While some adjustments are made for receivables and payables, it is not as comprehensive as under IFRS.
Depreciation and Amortization
IFRS: Assets are depreciated or amortized systematically over their useful lives, impacting both the income statement and balance sheet.
Modified Cash Basis: Depreciation may still be accounted for, but the systematic approach of IFRS is typically more rigorous.
Inventory Accounting
IFRS: Inventory is recorded at the lower of cost or net realizable value and uses methods like FIFO (First-In, First-Out) or weighted average cost.
Modified Cash Basis: Inventory may not be as rigorously accounted for until the actual cash transaction takes place.
Provisions and Contingencies
IFRS: Provisions for potential liabilities and contingencies are recognized when an entity has a present obligation as a result of a past event, it is probable that an outflow of resources will be required to settle the obligation, and the amount can be reliably estimated.
Modified Cash Basis: Such provisions may not be recognized until the related cash flows occur.
Implications of Modified Cash Basis Accounting
Using the modified cash basis of accounting can obscure the true financial health of a company, especially concerning retained earnings and overall solvency. This accounting method might not fully capture all liabilities and assets until related cash transactions occur, which can delay the recognition of important financial information.
The modified cash basis of accounting is expedient and simplifies record-keeping, providing business owners with insights into trends and movements. However, it sacrifices accuracy and completeness, making it less valuable for investors who need a comprehensive understanding of the company's financial health.
Inaccurate Financial Picture: The modified cash basis might not provide a complete and accurate picture of a company's financial position because it primarily records transactions when cash is exchanged. This can lead to significant timing differences in income and expense recognition, affecting the visibility of the company's ongoing financial health.
Risk of Misleading Dividend Decisions: Decisions regarding dividend payouts based on a modified cash basis might not take into account all existing liabilities or future obligations that have not yet required cash settlement. This can result in dividends being declared from what appears to be surplus cash, potentially depleting resources needed for future expenses or debt payments.
Importance of Supplementary Financial Management Tools
Companies using a modified cash basis should consider implementing additional financial management and monitoring tools. These could include more frequent liquidity ratio analyses, cash flow forecasting, and scenario planning to ensure that sufficient funds are available for operations and obligations after dividends are paid.
Need for Cautious Dividend Policy
Directors should be particularly cautious with dividend policies under the modified cash basis. It’s prudent to maintain conservative dividend payout ratios and possibly retain a larger buffer of retained earnings to safeguard against financial instability.
While the modified cash basis can be simpler and may suit certain business contexts, companies using this method should be particularly diligent in monitoring their cash flows and financial commitments. This is crucial to avoid compromising their financial stability and to ensure they remain well-positioned to meet their obligations.
With the legalities of dividends clearly laid out, let's shift our focus to the vital role that independent reviewers play in this regulatory landscape.
Independent reviewers and Dividends: When to submit a Reportable Irregularity
An independent reviewer is obligated to report a reportable irregularity to the CIPC if there's an act or omission by management that:
Unlawfully causes material financial loss to the company, or a member, shareholder, creditor or investor of the company,
Is fraudulent or amounts to theft, or
Leads to trading under insolvent circumstances (specifically commercial insolvency where the company cannot meet its debts).
If a company declares a dividend without conducting the required solvency and liquidity test, and this results in the company either being insolvent or becoming insolvent, it constitutes a reportable irregularity.
Scope of Review Engagements:
In a review engagement, the independent reviewer's responsibility to report irregularities such as trading under insolvent circumstances arises only if they become aware of such issues in the normal course of their review. They are not required to conduct investigations to uncover issues proactively.
If during their standard review procedures, which include inquiries and basic analytical assessments, the reviewer comes across evidence suggesting that a dividend payment or any other decision has led to insolvency or inability to pay creditors, they must then consider this a potential reportable irregularity.
While the reviewer is not expected to perform an exhaustive investigation like an auditor, they should follow up on any indicators of potential irregularities they encounter to a reasonable extent within the scope of a review engagement.
Responding to Awareness of Issues
Professional Judgment: When an independent reviewer becomes aware of potential insolvency issues, they need to use their professional judgment to determine the severity and the likelihood that it was caused by an action like a dividend payout. This could involve additional inquiries or limited targeted procedures to understand the context and implications better.
Reporting Requirements: If the reviewer concludes that there is a reasonable basis to believe the company has engaged in actions that contravene financial regulations (such as paying dividends when it causes the company to be unable to meet its obligations), they are obligated to report these findings according to the guidelines set by government agencies like the Companies And Intellectual Properties Commission (CIPC).
Procedures for Handling Reportable Irregularities by Independent Reviewers
When an independent reviewer believes a company has or is currently involved in a reportable irregularity they must act quickly to handle the situation.
Here’s a simple breakdown of what they need to do, explained in layman's terms for accountants:
Immediate Reporting: If an independent reviewer suspects that a company has engaged in any wrongdoing, they must immediately write and send a report to the Commission (the regulatory body overseeing companies). This report should detail the nature of the irregularity and may include any additional information the reviewer finds relevant.
Informing the Board: Within three business days of sending this report to the Commission, the reviewer must also inform the company’s board of directors in writing about the report they've sent. A copy of the report submitted to the Commission should be included in this communication to the board.
Follow-Up Actions:
Discussion with the Board: The reviewer should make efforts to discuss the contents of the report with the board as soon as reasonably possible, but no later than 20 business days after the initial report was sent to the Commission.
Opportunity for Board's Response: The board should be given a chance to respond to the report, offering their perspective or any additional information they think is relevant.
Second Report to the Commission: After these discussions, the reviewer sends another report to the Commission. This report should state whether the reviewer believes the irregularity has stopped, is still happening, or if it was never happening. It should also detail the steps taken to prevent further issues or recover any losses, if applicable.
Further Action by the Commission: If the irregularity is ongoing, the Commission, upon receiving the second report, may notify other relevant regulatory bodies and might investigate the matter further.
Investigative Authority: The independent reviewer has the authority to conduct further investigations if necessary to prepare these reports or to clarify any details about the suspected irregularity.
Duty of Care: In all actions, the independent reviewer must consider all available information, from any source, that could impact their understanding of the situation.
This process ensures that any suspected wrongdoing within a company is thoroughly investigated and reported, providing transparency and accountability, and allowing appropriate actions to be taken to address the issue.
Example reports
These examples cover initial notification to the Commissioner, informing board members, and a follow-up report. They are designed to help accountants and company directors understand the necessary steps and communications for dealing with irregularities effectively and transparently.
A) Report to the Commissioner on Reportable Irregularity
[Firm Letterhead]
[Date]
The Commissioner
Companies and Intellectual Property Commission
P.O. Box 429
Pretoria 0001
Email: independentreview@cipc.co.za
Subject: First Report on Reportable Irregularity
Dear Commissioner,
Reportable Irregularity: [Insert Company Name], [Insert Company Registration Number]
This letter is submitted in accordance with the requirements of Regulation 29(6) of the Companies Regulations 2011. As the appointed independent reviewer, I have engaged with [Insert Name of Company] to review the annual financial statements for the fiscal year ended [Insert Reporting Date].
Identification of Reportable Irregularity:
During the course of our review, we identified activities that meet the criteria of a reportable irregularity as outlined in the Companies Regulations 2011. These activities include [Provide concise description of the irregularity, mentioning specific sections of the Companies Act or other relevant legislation allegedly violated].
Notification and Compliance:
As mandated by Regulation 29(7), I will notify the board members of [Insert Name of Company] within three business days of this communication. A copy of this report will be included in the notice to the board.
Request for Acknowledgment:
Please acknowledge receipt of this report. I am available to provide any further information or clarification as needed.
Sincerely,
[Your Name]
[Your Title]
[Your Contact Information]
[Your Email Address]
B) Notification to Board Members on Reportable Irregularity
[Firm Letterhead]
[Date]
To the Members of the Board:
[Name of Company]
[Company Address]
Subject: Notification of Reportable Irregularity
Dear Board Members,
This letter serves to inform you that a reportable irregularity has been identified and reported to the Companies and Intellectual Property Commission (CIPC) as per the requirements of Regulation 29(7) of the Companies Regulations 2011.
Attached is a copy of the report submitted to the CIPC on [Insert Date of Report Submission], which details the nature of the irregularity. This irregularity pertains to actions that [Describe the nature of the actions leading to the irregularity].
Discussion and Representations:
In accordance with Regulation 29(8), I seek to discuss this report with you and offer the board an opportunity to make representations. I propose scheduling a meeting at your earliest convenience to address this matter comprehensively.
Please confirm receipt of this letter and suggest possible dates for our meeting.
Yours faithfully,
[Your Name]
[Your Title]
[Your Contact Information]
[Your Email Address]
C) Second Report to the Commissioner on Reportable Irregularity
[Firm Letterhead]
[Date]
The Commissioner
Companies and Intellectual Property Commission
P.O. Box 429
Pretoria 0001
Email: independentreview@cipc.co.za
Subject: Second Report on Reportable Irregularity: [Insert Company Name], [Insert Company Registration Number]
Dear Commissioner,
Following my initial report dated [Insert Date of First Report], I have engaged in discussions with the board members of [Insert Name of Company] regarding the identified reportable irregularity. During these discussions, we reviewed the issues at hand and considered the board's representations.
Outcome of Discussion:
Based on further investigations and the discussions with the board, I [Choose one: conclude that the reportable irregularity is no longer occurring / confirm that the reportable irregularity continues]. [If applicable, describe any actions taken by the company to rectify the irregularity.]
Detailed Information Supporting Conclusion:
[Provide detailed particulars and information supporting the conclusion about the irregularity’s current status.]
Please acknowledge receipt of this comprehensive follow-up report.
Yours faithfully,
[Your Name]
[Your Title]
[Your Contact Information]
[Your Email Address]
Overview of the Independent Review Specialist License for Accountants
Why You Need This License:
If you're a Business Accountant in Practice (BAP(SA)), obtaining an Independent Review Specialist License is essential for gaining recognition and registration as an independent reviewer by the CIPC (Companies and Intellectual Property Commission). This license verifies your ability to conduct independent reviews, a requirement for certain businesses under the Companies Act.
How to Obtain the License:
To secure this license, you must demonstrate your expertise by passing an exam developed by independent industry experts and accredited by CIBA (Chartered Institute of Business Accountants). The exam assesses your knowledge and skills in specific areas of independent reviewing.
Benefits of the License:
Holding this license allows you to:
Meet your legal obligations under specific sections of the Companies Act and Regulations.
Apply industry-standard practices and the International Standard on Review Engagements 2400 (ISRS 2400) in your reviews.
Command higher fees and profit margins due to your specialist skills.
License Details:
The license, priced at R2,500 with an annual renewal fee starting at R550, is not refundable. It's crucial to ensure you meet all the prerequisites before purchase, as no refunds will be issued for non-compliance. This license is standalone and does not come as part of any subscription package.
What's Included:
The license provides access to comprehensive study materials to prepare you for the assessment. The curriculum includes topics from ethics and client engagement to performing and completing the review, and issuing a report. Assessments involve multiple choice and essay questions.
Entry Requirements:
To enroll, you need:
A BAP(SA) or equivalent designation at NQF level 7,
CIBA membership,
At least 3 years of general accountancy experience.
Alternatively, if you lack the BAP(SA) designation, you can qualify through CIBA’s competency recognition routes.
CPD Credits:
Successfully completing this license contributes 25 hours towards your CPD requirements, with 6.25 hours eligible for accounting CPD credits, in line with CIBA’s CPD policy.
This license ensures you are equipped to perform independent reviews effectively, enhancing your professional credibility and service quality in the accounting field. If unsure about compliance with the requirements, reach out to academy@saiba.org.za for guidance.