In the November issue of dReport, we informed you about principal impacts of an amendment to Act No. 90/2012 Coll., on Business Corporations and Cooperatives (hereinafter the “Business Corporations Act”). In today’s article, we would like to present you more details on conditions that must be met before the payment of profit shares or advances on profit shares.
Payment of profit shares
The amended version of the Business Corporations Act has taken over the existing case law and confirms that profit shares can be paid pursuant to a general purpose or special purpose financial statements approved by the supreme body until the end of the following reporting period. For this reason, it has been conclusively addressed that it is not necessary to prepare the special purpose financial statements even when the decision on the distribution of the profit and other own resources is made after 6 months from the balance sheet date (as numerous companies feared given the prior wording of the Commercial Code). Protection to shareholders, creditors or other involved parties against excessive payment of funds is provided by tests that are currently included in Sections 34, 35 and 40 of the Business Corporations Act.
The statutory body of a capital company or a cooperative may decide on the payment of profit shares only when the following balance sheet tests are satisfied:
- Test for distribution of resources under Section 34 of the Business Corporations Act
- Test for a deficit on equity under Section 40 of the Business Corporations Act
- Test for coverage of development costs under Section 40 of the Business Corporations Act
Test for distribution of resources
Section 34 of the Business Corporations Act stipulates that “the amount to be distributed shall not exceed the total of the profit or loss for the most recent reporting period, profit or loss of prior years and other funds that the company may … use at its discretion, decreased by allocations to the reserve fund and other funds in accordance with the act and the articles of incorporation”.
This balance sheet test remains in an unchanged structure as before the amendment, the difference being that it is newly applied not only to joint stock companies, but also to limited liability companies and cooperatives.
There is also a new specification, which was however used in practice before, that it is possible to distribute, and therefore submit to the test, not only resources presented in items A.IV.1. Accumulated profits or losses brought forward and A.V. Profit or loss for the current period, but also other own resources, i.e., funds from profit or capital funds that may be distributed – e.g., own resources presented in items A.II.1. Share premium, A.II.2. Capital funds, A.IV.2. Other profit or loss from prior years.
It is not possible to distribute the funds (and they are deducted from the amount to be distributed for this reason in the test) whose origination, change or expiry is stipulated by a legal regulation or the articles of incorporation in a way that does not allow their distribution. This category includes for example gains or losses from the revaluation of assets and liabilities to fair value presented in item A II.2.2. Gains or losses from the revaluation of assets and liabilities.
It is not possible to distribute own resources (and they are deducted from the amount to be distributed for this reason in the test) presented in items A. III. Funds from the profit (e.g., Other reserve funds, Statutory and other funds). These funds can be distributed, and consequently included in the test, only in cases when it is allowed by the articles of incorporation, articles of association, collective agreement, intracompany guideline or another legal regulation or another limiting circumstance. The funds presented in these items are usually used for purposes other than for the distribution to the shareholders or owners – they are amassed for example for the social needs of the employees or to cover possible losses, and therefore they will not be included in the balance sheet test under Section 34.
Test for a deficit on equity
Section 40 of the Business Corporations Act stipulates that “a company may not distribute the profit or other own resources, if the equity arising from the general purposes or special purpose or equity after the distribution drops under the amount of the subscribed share capital increased by the funds that cannot be distributed in accordance with the act or the articles of incorporation as of the end of the most recent reporting period”.
Unlike the first test, this test takes into account all equity presented in item A. Equity. It means that item A.I. Share capital is included. This test prevents the distribution of the profit and other resources in cases when negative items are presented in equity (for example in the above mentioned item A.II.2.2. Gains or losses from the revaluation of assets and liabilities or treasury shares and holdings in item A.I.2.) which eventually result in total equity being lower than the subscribed share capital, even though the company reports a profit in the reporting period and other positive own resources that can be distributed.
Test for coverage of developments costs
The test for the coverage of development costs was moved from the Act on Accounting, so the conditions for the distribution of the profit and other own resources are concentrated in one piece of legislation. This test defines a situation when development costs are presented in assets in the balance sheet. Section 40 of the Business Corporations Act stipulates that a company “shall not distribute the profit or other own resources, if the amount to be distributed does not, at least, equal the unamortised part of the development costs. The amount to be distributed shall be decreased by the unamortised development costs”.
In practice, it means that own resources to be distributed, that passed both previous tests, must be distributed in the amount decreased by the net item B.I.1. Development. We recommend paying attention to the test of the existence of unamortised development costs also in respect of a different practice in presentation of development costs by various entities in various industry sectors, primarily in items C.II.3.2. or D.2. Complex deferred expenses.
Advances on profit shares
Advances on profit shares are defined in Section 35 of the Business Corporations Act. Advances on profit shares may be paid solely pursuant to interim financial statements that will indicate that a company has sufficient resources for profit distribution. Here, it is also necessary to perform a balance sheet test for the distribution of resources that requires, identically as in the payment of profit shares, that the “total of the advances on profit share may not exceed the total of the profit or loss for the reporting period, profit or loss of prior years and other funds from profit that a business corporation may use at its own discretion, decreased by allocations to reserve and other funds in accordance with the act and the articles of incorporation”.
Advances on profit share should be accounted for already when a decision on their granting is made. This is in line with the accounting procedure described in Regulation No. 500/2002 Coll. and Czech Accounting Standard no. 018, when, on the part of the paying company, equity line “A. VI. Profit share prepayments declared” is used against a liability to the owners in account group 36. This liability is settled at the moment when the advance is paid. The paid advance on profit share decreases the amount of the equity. If a company finds out, from the general purpose financial statements, that the paid advances on profit share exceed the amount that the company could pay as profit shares, an entitlement arises for the return of the advance paid and a receivable from the owners is recognised (at the moment then the company finds out such fact).
On the part of the receiving company the accounting treatment is not clearly specified. At present, there are 2 possibilities:
a) Recognition of the advance received in income
The procedure is an analogy to the recognition on the part of the paying company (it accounts for a decrease in equity), i.e., the receiving company recognises in income and it increases equity of the receiving company through a higher profit. Given the conditioned receipt of the advance on the profit share, or the possibility of the return of the profit share, this procedure is not recommended as the income should be reported only at the moment when it is clearly recognised, i.e., the profit share is approved by the general meeting.
b) Accounting for the received advance in liabilities
It is a conservative solution that adheres to applicable Czech regulations. The reason for the accounting for a liability is the conditionality of received profit shares, as the recipient has an obligation to return the received fund if the profit share is not approved by the general meeting. Income will be subsequently recognised in income at the moment when approved by the general meeting.