The recognition of a profit in the financial statements does not automatically mean that it may be paid to members or shareholders. Before deciding on the distribution of profit and subsequently making the payment, a company must verify that several statutory conditions have been met. This article summarises four key tests, the responsibilities of the company’s individual governing bodies and the rules governing the payment of advances on profit shares.
The distribution of profit and other equity of business corporations is governed primarily by Act No. 90/2012 Coll., on Commercial Companies and Cooperatives (the Business Corporations Act, the “BCA”).
Under Section 34 of the BCA, profit shares are determined based on ordinary or extraordinary financial statements approved by the supreme body of the business corporation and may be distributed until the end of the following reporting period. The general meeting must consider and approve the ordinary financial statements no later than six months after the last day of the preceding reporting period. For a limited liability company, this time limit follows from Section 181(2) of the BCA; for a joint-stock company, it follows from Section 403(1) of the BCA. If the financial statements are subject to a statutory audit, the auditor’s verification should take place before the financial statements are approved.
If a payment is to be made before the ordinary or extraordinary financial statements have been approved, it constitutes an advance on a profit share and the conditions laid down in Section 35 of the BCA must be met separately, in particular the preparation of interim financial statements.
Shareholders, creditors and other stakeholders are protected against excessive distributions of funds by the tests set out in Sections 34, 35 and 40 of the BCA.
The statutory body of a capital company or cooperative may decide to pay profit shares only if the following statutory tests are met:
The first three tests determine whether, and to what extent, profit or other equity may be distributed. The insolvency test applies when the payment is made and considers the company’s current financial position.
Distributable amount test (the balance-sheet test)
The balance-sheet test applies to joint-stock companies, limited liability companies and cooperatives.
Under Section 34(2) of the BCA, the amount to be distributed must not exceed the sum of:
less mandatory allocations to reserve and other funds.
A resolution of the supreme body that fails to comply with this limit has no legal effect.
In practice, the following formula may be used:
Maximum distributable amount = profit for the most recent period + profit or loss from prior years (including other profit or loss from prior years) + distributable funds (selected other capital funds) – mandatory allocations to funds
Funds whose creation, modification or dissolution is governed by legislation or the articles of association in a manner that does not permit their distribution cannot be used for distribution. This category includes, for example, valuation differences arising from the remeasurement of assets and liabilities to fair value recognised under item A.II.2.2 Gains or losses from the revaluation of assets and liabilities. It may also include item A.II.1 Share premium or funds earmarked for a specific purpose, such as a social fund or reserve fund.
Funds recognised under these items are generally intended for purposes other than distribution to shareholders or members. For example, they may be created to meet employees’ social needs or cover potential losses. Their value will therefore not be included among distributable funds for the balance-sheet test.
Equity test
Under Section 40(1) of the BCA, a capital company or cooperative must not distribute profit or other equity if the equity reported in the ordinary or extraordinary financial statements is lower than the subscribed share capital plus non-distributable funds. The same prohibition applies if the proposed distribution would cause equity to fall below this threshold.
This test is based on total equity. Negative components of equity, such as treasury shares and holdings and negative valuation differences, must therefore also be taken into account. Consequently, a company may fail the test even if it reported a profit for the most recent period and has positive distributable retained earnings.
Test for coverage of unamortised development costs
If unamortised development costs are recognised as assets in the balance sheet, Section 40(2) of the BCA requires the distributable amount to be reduced by their unamortised amount. If the distributable amount is not at least equal to the unamortised portion of the development costs, the company must not distribute profit or other equity.
In practice, this means that equity available for distribution which satisfies both preceding tests may be distributed only after being reduced by the net carrying amount reported under item B.I.1 Development, or under any other items in which development costs are recognised. For example, in the automotive and other engineering sectors, development costs may be reported under item C.II.3.2 or D.2 Complex deferred expenses.
Insolvency test
Under Section 40(3) of the BCA, a business corporation must not pay a share of profit or other equity if the payment would render it insolvent within the meaning of Act No. 182/2006 Coll., the Insolvency Act. The same rule applies to the payment of an advance on a profit share.
A company is insolvent if it is unable to pay its debts (it has several creditors and monetary liabilities at least 30 days overdue which it is unable to discharge) or if it is over-indebted within the meaning of Section 3(4) of the Insolvency Act.
Unlike the preceding three tests, which are assessed as at the date of the most recent financial statements, the insolvency test assesses the current position at the time of payment and is performed by the statutory body immediately before payment. The statutory body is required to act with due managerial care and should therefore not only perform the insolvency test but also verify the accuracy of the balance-sheet test, the equity test and the test for coverage of unamortised development costs.
If a profit share is not paid by the end of the reporting period because the insolvency test has not been met, the right to payment lapses under Section 40(4) of the BCA. The unpaid amount is credited to the account to which it was originally charged or, if this is no longer possible, to retained earnings from prior years.
Under Section 35 of the BCA, an advance on a profit share may be paid only based on interim financial statements showing that the company has sufficient funds available for the distribution of profit. The aggregate amount of advances must not exceed the statutory limit, and the payment must not render the company insolvent.
Here too, a balance-sheet test of distributable funds must be performed. As with payments of profit shares, this test requires the company to ensure that “the aggregate amount of advances on profit shares may not exceed the sum of the profit or loss for the current reporting period, profit or loss from prior years and other funds created from profit which the business corporation may use at its discretion, less allocations to reserve and other funds in accordance with the law and the articles of association”. Allocations, particularly to reserve and social funds, are often overlooked when advances are determined, even though in some cases they may amount to 5% to 10% of the expected net profit for the period.
It should also be noted that interim financial statements are defined by Act No. 563/1991 Coll., on Accounting (the “Accounting Act”), specifically in Section 6(4), and must contain all the components of financial statements required by Section 18, i.e. the statements and notes included in ordinary financial statements. They must also be prepared using measurements in accordance with Section 25(3) of the Accounting Act. In practice, this means updating depreciation and amortisation, impairment allowances and provisions, and recognising relevant estimates, including an estimate of current income tax, as well as carrying out remeasurement to fair value where required by law, for example for derivatives. Management reports or a trial balance therefore cannot be used as the basis for a decision to pay advances on profit shares.
Advances on profit shares are recognised when the decision granting them is made. This is also reflected in the accounting treatment described in Decree No. 500/2002 Coll. and Czech Accounting Standard No. 018. In the paying company’s accounts, the negative equity item “A.VI. Profit share prepayments declared” is recognised against a liability to members or shareholders recorded in account group 36. This liability is settled when the advance is paid. An advance paid on a profit share reduces equity.
If the ordinary or extraordinary financial statements show that the final profit share is lower than the advance paid, the recipient must repay the difference within three months of the date on which the financial statements were, or should have been, approved. In that case, the company recognises a receivable from the recipient of the advance.
A different situation arises if a share of profit or other equity has been paid even though the statutory conditions for its distribution or payment were not met. The BCA provides that a resolution of the supreme body that contravenes the statutory distribution limits has no legal effect and that the statutory body must not make a payment contrary to law. Members of the statutory body who approved such a payment may be liable for a breach of their duty of due managerial care.
The legal and accounting consequences of a payment already made must be assessed in light of the specific circumstances, in particular the statutory restriction breached, the recipient’s position and the possibility of seeking repayment. Such a situation therefore need not in every case be dealt with automatically in the same way as the repayment of an excess advance. The accounting treatment of any correction must be based on a legal assessment of the company’s claim.
Profit distribution is one of the most significant areas of decision-making for business corporations and requires careful consideration of both economic and legal factors. Although distributable profit may appear sufficient at first sight, recognising a profit in the accounts does not automatically mean that it may be paid to owners. Compliance with all statutory restrictions, particularly the balance-sheet test, the equity test and the insolvency test, is crucial.
The individual tests should not only be calculated but also properly documented. The documentation should record the figures used from the financial statements, the assessment of distributable and non-distributable funds, the company’s current financial position and the statutory body’s conclusion. A properly designed profit distribution process helps prevent the risks associated with unlawful payments of profit shares, which may lead not only to an obligation to repay the amounts paid but also to liability on the part of members of the statutory body.
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