The issue under consideration is the accounting disclosure for the portion of the revenue reserves that are declared to be non-distributable by way of a decision of the Board of Directors of a company, to be subsequently approved by the shareholders. This writer’s comments and views on the matter are as under:
1 Accounting Standards: Under the International Financial Reporting Standards (IFRS), there is neither a specific definition of ‘reserves’ nor is there any basis laid down for the purposes of classification of reserves as capital and revenue reserves.
The guidelines from an international accounting firm on this matter state that some reserves result from accounting requirements (for example, fair value and foreign currency translation reserves) to reflect certain measurement changes in other comprehensive income rather than the statement of profit or loss.
These separate reserves are often reclassified (recycled) from other comprehensive income to the statement of profit or loss when the related assets and liabilities are derecognised or impaired. Other reserves arise from jurisdictional requ irements.
2 Nevertheless, it has been a consistent practice of companies complying with the IFRS in the past that a classification is made between capital and revenue reserves, if required, on the basis of ‘source’ from which such reserves are generated.
In other words, capital reserves are only those reserves that originate from capital transactions. Income generated from normal operations of a company cannot give rise to any capital reserve. This classification is essentially derived from the substance over form concept which is the underlying theme for all accounting standards.
3 Evolution of Corporate Law: This distinction has effectively and practically been abandoned by corporate regulators which, in our opinion, include Pakistan’s. The reason for this abandonment is a pragmatic and practical approach to the subject.
Corporate regulators appear to be more progressive and prudent as they are highly interested in the proper disclosure of ‘distributable’ and ‘non-distributable’ reserves. It is for this reason that in the absence of this requirement there are chances of distribution by way of cash dividend, an income that has actually not been earned.
4 There are varied applications on this matter in corporate laws of various countries. For example, in the UK, the term ‘undistributable profit’ has been introduced in the legislation, which has been defined in the corporate law in a strict legal sense. This definition states that any other reserve that the company is prohibited from distributing by way of its articles is also an undistributable reserve.
5 This, therefore, concludes the basis of classification as to capital or revenue reserve, if so required, is not to be deduced from accounting standards. It is a matter of compliance of reporting requirements under the corporate laws of the country, which is the Companies Act, 2017 in Pakistan. In Pakistan this disclosure requirement is placed under the Fourth Schedule to the Companies Act, 2017.
6 Corporate Law Requirements in Pakistan: In the Fourth Schedule of the Companies Act, 2017 this matter is dealt with as under:
“capital reserve” includes:
(i) share premium account;
(ii) reserve created under any other law for the time being in force;
(iii) reserve arising as a consequences of scheme of arrangement;
(iv) profit prior to incorporation; and
(v) any other reserve not regarded free for distribution by way of dividend
...
“revenue reserve” means reserve that is normally regarded as available for distribution through the profit and loss account, including general reserves and other specific reserves created out of profit and un-appropriated or accumulated profits of previous years;
23 Capital and Revenue reserves shall be clearly distinguished. Any reserve required to be maintained under the Act shall be separately disclosed. Any legal or other restrictions, on the ability of the company to distribute or otherwise, shall be disclosed for all kind of reserves maintained by the company;
7 An analysis of corporate regulations: In our opinion the Pakistan corporate law disclosure is apparently consistent with the concept of capital reserves as referred above. However, the word used with capital reserves is ‘includes’, which means that this is not a comprehensive ambit.
8 This structure can be interpreted in two senses. Under one sense, this means that this classification may include something which is not ‘per se’ a capital reserve but is so classifiable for this specific purpose. This implies that oranges can be placed even if the subject relates to apples. This mode may specifically be applicable for “(v) any other reserve not regarded free for distribution by way of dividend”.
9 In another sense, which is a conservative view, this provision reflects that a reserve has to be ‘intrinsically’ a capital reserve as identified in paragraph 2 to find a place under this classification.
It is our view that the intention of law may include only those capital reserves which are intrinsically capital in nature; however the use of the words ‘includes’ and the words ‘any other reserve not regarded free for distribution by way of dividend’ provide enough latitude to take a non-conservative position.
10 It is also required to be noted that under the Pakistan law the word ‘dividend’ is restricted to cash dividend and whenever there is a reference to bonus shares there is a separate use of the word ‘bonus shares’. This can therefore mean that reference in clause (v) relates to cash dividend only.
11 In the same context, on the contrary, if we examine the definition of ‘revenue reserves’ the word used is ‘means’ which exhibits that this is an exhaustive definition. All the reserves which are revenue reserves have to be included under this head. No reserve, which is intrinsically a revenue reserve, can be taken out from this classification for completion of disclosure of revenue reserve.
12 Without prejudice to paragraph 11 if the definition of revenue reserve is read in practical context especially the words “normally regarded as available for distribution through the profit and loss account” it can be stated that this does not represent an all-encompassing ambit of revenue reserves.
The text actually reflects a varied form of definition of ‘distributable reserves’. The words contained after the word ‘including’ in this definition have been placed to state that any amounts not appearing in profit and loss accounts out of which dividend can be distributed such as general reserve, specific reserves such as reserves for redemption of shares, etc., are also to be classified as revenue reserve.
In this situation the fundamental question with reference to the issue under consideration is whether a reserve which is intrinsically a revenue reserve can be placed under the inclusive head of capital reserve and not included in the revenue reserves.
13 Indian position and other definitions: Before answering the aforesaid question it would be better to examine the provisions in other jurisdictions and the concept generally applicable. ‘Capital reserve’ is generally defined as under:
A capital reserve is a line item in the equity section of a company’s balance sheet that indicates the cash on hand that can be used for future expenses or to offset any capital losses. It is derived from the accumulated capital surplus of a company and is created out of its profit.
14 A famous Indian writer on corporate law describes capital reserves as:
A capital reserve is an anachronism because the term ‘reserve’ is not defined under generally accepted accounting principles (GAAP). It is created through transactions of a capital nature, such as selling fixed assets, the upward revaluation of assets to reflect their current market value, profits on the redemption of debentures, and the reissue of forfeited shares.
Capital reserve has nowhere been specifically defined in the Companies Act, 2013 or anywhere in Accounting Standards but taking the cue of references made of Capital Reserve at various instances in Accounting Standard 12, 14 and elsewhere we can construe that Capital Reserve is generated out of Capital Gains of the Company which may include profit out of sale of undertakings, profit out of revaluation of Capital Assets etc.
15 The concept of ‘free reserves’. There is a concept of ‘free reserves’ in our corporate law structure and India. This term is also a varied name of distributable reserves. There was a specific detailed definition of ‘free reserves’ in the Companies (Further Issue of Shares) Regulations 2018 which has been deleted through amendments in 2020.
However, there are inferences in various provisions of law. The objective of the exercise is to identify that a portion of free reserves is not available for cash distribution and that effect has been given in the financial statement.
16 The specific issue: If we examine the context of the whole discussion of classification of capital and revenue reserves in the context of the objective of the exercise, the moot point is that capital reserves are those reserves which cannot be distributed in cash.
Their origin— source or manner of creation— is now not relevant to corporate law purposes. We consider that there is no difference of view to this extent under any jurisdiction or any form of interpretation by any person.
17 The issue is limited to the determination of the amount that can be distributed in the form of ‘cash dividend’. It is for this reason the UK legislation has specifically used the term ‘undistributable reserves’.
This leads to the secondary question of whether or not this restriction can arise on account of intrinsic nature such as share premium or by an action being the voluntary decision by the Board of Directors or the Articles of Association of a company as the case may be.
We do not see any difference between the two and consider that even a decision of the Board which in reality cannot be ignored. Unless reversed, this amount cannot be distributed in cash.
Standard Caveats
a) This is an academic writing based on the facts and assumptions stated herein. Any inaccuracy in them could have a material impact on the analysis or conclusions.
b) It is based on the law as of date. Tax and other laws (referred herein) are subject to changes from time to time and as such any change(s) may affect the view expressed herein.
c) It contains interpretation of law and is based on the writer’s experience with the tax and other relevant authorities. Accordingly, it cannot be said with certainty that the view expressed in this article will be accepted by the tax and other relevant authorities.
Copyright Business Recorder, 2023
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